Academic journal article Federal Reserve Bank of New York Economic Policy Review

Are Home Prices the Next "Bubble"?

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Are Home Prices the Next "Bubble"?

Article excerpt

* Home prices have been rising strongly since the mid-1990s, prompting concerns that a bubble exists in this asset class and that home prices are vulnerable to a collapse that could harm the U.S. economy.

* A close analysis of the U.S. housing market in recent years, however, finds little basis for such concerns. The marked upturn 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.

* Moreover, weaker economic conditions are unlikely to trigger a severe drop in home prices. Historically, aggregate real home prices have fallen only moderately in periods of recession and high nominal interest rates.

* While such conditions could lead to lower home prices in states along the east and west coasts--areas where an inelastic supply of housing has made home prices particularly sensitive to changes in demand--regional price declines in the past have not had devastating effects on the broader economy.

1. INTRODUCTION

The rapid increase in home prices over the past several years has raised concerns about the existence of a speculative bubble in this asset market. A closely related concern--irrespective of any existing bubble--is whether home prices are susceptible to a steep decline that could have a severe impact on the broader economy.

Indeed, home prices have been rising rapidly. Since 1995, real home prices have increased about 36 percent, roughly double the increase of previous home price booms in the late 1970s and late 1980s (Chart 1). (1) Moreover, home prices continued to rise strongly during the 2001 recession, the sluggish recovery through mid-2003, and the recent period of more rapid growth.

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Many analysts argue that the recent growth in home prices is symptomatic of a housing bubble that will burst--just as the stock market bubble did--thus erasing a significant portion of household wealth. (2) They add that such a decline in household wealth would have adverse macroeconomic effects, as already overextended consumers reduce spending to boost saving and improve their weakened financial condition.

In this article, we assess the evidence in support of a bubble in U.S. home prices and discuss whether a severe decline in these prices is likely. We also examine the effects of a steep drop in home prices on the broader national economy.

Examining the possible effects of a severe decline in home prices is important because of the large role that real estate plays in aggregate household portfolios. According to the Flow of Funds Accounts compiled by the Board of Governors of the Federal Reserve System, households held about $14.6 trillion in real estate at the end of 2003:3. This figure accounts for about 28 percent of households' assets and is more than 130 percent of GDP. By comparison, households held about $12.8 trillion of corporate equities and mutual funds in 2000:1--the peak of the stock market. Furthermore, equity holdings are concentrated at the upper end of the wealth distribution, whereas housing is the major asset for most households. (3)

Economists have identified a number of ways in which fluctuations of home prices and home price bubbles could affect the aggregate economy. Higgins and Osler (1998) find evidence of regional home price bubbles around 1989 that had a negative effect on residential investment, and thus aggregate output, in those regions. (4) Another potential effect of a severe home price decline could come from a consumption "wealth effect." Although the magnitude of this effect remains controversial in some quarters, a number of studies--including Case, Quigley, and Shiller (2001), Skinner (1996), and Case (1992)--find significant wealth effects from housing assets. (5) If the magnitude of the wealth effect from housing is around 5 percent, which is a widely used estimate, (6) then a severe decline in home prices could lead to reductions in consumption of around $150 billion, which is just slightly less than 2 percent of total personal consumption expenditures. …

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