Something positive seems to be happening in the property market, with recent data showing prices are stabilising across the State.

Nobody, not even estate agents, dares talk of recovery but things seem to have changed for the better. Dermot O’Leary of Goodbody put it well last week when he wrote that prices have returned to fair value and “the latest data suggest that a new cycle in Ireland’s volatile property market is starting to take hold”.

The most prophetic word here is “volatile”. Fresh research from the Central Bank*, also published last week, found the Irish property market is exceptionally volatile for a number of reasons.

The good news is that the Central Bank economists have also come to the conclusion Irish property prices have fallen to fair value or possible below it. They do so based on something called the user cost of capital, a concept we are all familiar with from the last decade: it was cheaper to buy than to rent. Or in Central Bank speak: the cost of accessing a given bundle of housing services via home ownership was lower than renting in the private market.

Rental versus purchase
The cost of renting versus the cost of buying has an important stabilising effect on house prices and should balance out over time as market forces – such as rents, interest rates, price expectations, etc – play off against one another.

This should have happened in Ireland between 2002 and 2007 – the height of the boom but didn't. Rents did not fall (because of a shortage of houses) and interest rates did not rise (because the banks had access to foreign money).

The relative cheapness of home ownership combined with the turbo-charging effect of ever-increasing price expectations created the boom. All three combined in a negative fashion once the bubble burst, producing the crash, and it is now decidedly cheaper to rent than buy, hence the conclusion that prices have undershot.

If – as seems reasonable – we are at the start of a new cycle, the Central Bank paper raises two very interesting questions. The first: to what extent are the factors that led to buying becoming cheaper than renting still latent in the economy? The second: what should be the correct policy response if they are?

The answer to the first question should become apparent soon enough. There seems to be general agreement that – in Dublin at least – there is a shortage of family homes and rents are under upward pressure. Interest rates remain preposterously low, but the Irish banks cannot access funding easily and are not lending.

If the seeds of the next boom are in fact already being sown, it will pose a conundrum for the Government. There is probably no better tonic for consumer confidence than sustained appreciation in house prices which would eat into negative equity. It would also be very beneficial to the balance sheets of the banks.

On this basis, the correct policy response is to sit back and let the market rip for a few years and then look at some of the measures the Central Bank has suggested could be used to dampen the excessive – and potentially catastrophic – volatility in the Irish market. These include higher capital gains tax, possibly even on principal private residences. The local property tax is also a powerful potential tool.

However, before getting carried away with this attractive idea, you have to realise that even the most optimistic of analysts are only saying that house prices are pretty much where they should be.

Threat of boom
This implies even a managed mini-boom would be bad thing from the perspective of the wider economy. It would very quickly eat into the improved competitiveness of Irish business that has underpinned the export sector. This analysis would argue the correct policy response is to move very quickly, once the market is close to equilibrium in terms of renting versus buying, and ensure no boom takes hold.

It is quite a thorny issue for policymakers, but when you think about the problems they have had to grapple with over the last five years you suspect it's a dilemma they would be happy to face.

*Understanding Irish House Price Movements – a User Cost of Capital Approach by Frank Browne, Thomas Confey and Gerard Kennedy