Thursday, July 08, 2004

Are Home Prices the Next Bubble ?

Jonathan McCarthy is a senior economist and Richard W. Peach
a vice president at the Federal Reserve Bank of New York.

(Read the entire PDF, by clicking on the link above.)

Recapping a forthcoming article from the Economic Policy Review.

* Home prices have been rising rapidly since the mid-1990s. Many analysts view the increase as symptomatic of a bubble that will burst, thus erasing a significant portion of household wealth. This decline in wealth could have a negative effect on the broader economy as consumers reduce spending to increase saving and protect their vulnerable financial condition.

* Authors McCarthy and Peach argue that no bubble exists and present evidence that the marked rise in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates.

* The authors begin their analysis by pointing out flaws in the two measures often cited to support the theory that a bubble exists—the rising price-to-income ratio and the declining rent-to-price ratio. Specifically, the measures

o do not account for the effects of declining nominal mortgage interest rates and

o fail to use appropriate home price indexes that control for location and changes in quality.

* McCarthy and Peach contend that a weakening of economic conditions is unlikely to trigger a severe drop in home prices. In fact, aggregate real home prices historically have fallen only moderately in periods of recession and high nominal interest rates.

* Nevertheless, weakening fundamentals could pressure prices along the east and west coasts, where an inelastic housing supply has made prices more volatile than elsewhere in the United States. However, previous home price declines in these regions have not had devastating effects on the national economy.


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