No bubble in housing?
The Federal Reserve Bank of New York put out a report last week stating that there is no bubble in the US housing market.
Home prices in the US have been rising strongly since the mid-1990s. Many economists think that the housing market is a bubble and that home prices are vulnerable to a collapse that could in turn adversely affect consumer spending and hurt the US economy, especially if the Federal Reserve Board raises interest rates.
However, the Federal Reserve Bank of New York report, written by Jonathan McCarthy, a senior economist, and Richard W. Peach, a vice president at the bank, has a different take. It concludes that the 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," it states.
To arrive at this conclusion, the authors used a constant-quality new home price index that takes into account the physical and locational characteristics of homes, rather than the more commonly-used index tracked by the Office of Federal Housing Enterprise Oversight. This is to adjust for improvements in quality over time.
Using the constant-quality new home price index, the authors show, using both cash flow affordability and an asset valuation model, that "given the steep decline in interest rates, home prices do not appear to be at unusually high levels".
The authors also think that home prices are not likely to plunge even if fundamentals deteriorate as home prices are less volatile than those for other assets, such as equities.
Not everyone agrees with the report's conclusion.
Ian Morris, chief US economist at HSBC, thinks a bubble exists and prices are likely to deflate gradually over a few years, triggered by interest rate rises. "This bubble-psychology has manifested itself in very rich valuations," he wrote in a report released on Friday titled "The U.S. Housing Bubble -- The case for a home-brewed hangover".
"Expectations of future house price appreciation are spectacularly, and unrealistically, high," he wrote.
Morris has doubts about the use of the quality-adjusted home price index. He thinks the existing stock of housing does not show the same improvement in quality as new homes.
Mark Weisbrot, co-director of the Center for Economic and Policy Research in Washington, DC, also thinks that there is a housing bubble. In his article "Greenspan Should Respond to Housing Bubble" on 24 June, he urges the Federal Reserve chairman Alan Greenspan to emulate Mervyn King, Governor of the Bank of England, who had sounded the warning in the UK that "the chances of falls in house prices are greater than they were".
"The bigger the housing bubble grows, the greater will be its negative impact on the economy when it bursts," writes Weisbrot.
"The Fed Chairman is supposed to be the country's most fearless economic watchdog, appointed to be independent of political pressures, willing to speak the truth and take the heat for 'pulling the punch bowl away just as the party is getting started.' If he won't warn the public of dangerous bubbles in asset prices, who will?"
Those who are familiar with Greenspan's thinking would know that he would probably not acknowledge a bubble even if it were staring at him in the face. Back in 2002, in defending his failure to act earlier to deflate the stock market bubble of the late 1990s, he had said that "it was very difficult to definitively identify a bubble until after the fact -- that is, when its bursting confirmed its existence".
Back in the late 1990s, Greenspan would have been concerned that any tightening action taken to deflate the stock bubble could also harm the economy. Unfortunately, the problem today could be worse. With American households more heavily indebted than ever, a housing bubble may be needed just to keep the US economy going.
As Richard Russell wrote in the Dow Theory Letters earlier this month: "I believe the Fed's fighting the global forces of DEFLATION. I think that Greenspan is afraid that the American consumer is 'tapped out.' And that consumers are very close to cutting back on their spending. The Fed's defense against a 'disastrous' consumer cut-back is to keep asset inflation going."
On 30 June, the Federal Reserve meets to discuss its next move in monetary policy. With near-unanimity among economists that the Federal Reserve will begin its tightening cycle at the meeting, we will soon know whether there is a housing bubble.
Home prices in the US have been rising strongly since the mid-1990s. Many economists think that the housing market is a bubble and that home prices are vulnerable to a collapse that could in turn adversely affect consumer spending and hurt the US economy, especially if the Federal Reserve Board raises interest rates.
However, the Federal Reserve Bank of New York report, written by Jonathan McCarthy, a senior economist, and Richard W. Peach, a vice president at the bank, has a different take. It concludes that the 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," it states.
To arrive at this conclusion, the authors used a constant-quality new home price index that takes into account the physical and locational characteristics of homes, rather than the more commonly-used index tracked by the Office of Federal Housing Enterprise Oversight. This is to adjust for improvements in quality over time.
Using the constant-quality new home price index, the authors show, using both cash flow affordability and an asset valuation model, that "given the steep decline in interest rates, home prices do not appear to be at unusually high levels".
The authors also think that home prices are not likely to plunge even if fundamentals deteriorate as home prices are less volatile than those for other assets, such as equities.
Not everyone agrees with the report's conclusion.
Ian Morris, chief US economist at HSBC, thinks a bubble exists and prices are likely to deflate gradually over a few years, triggered by interest rate rises. "This bubble-psychology has manifested itself in very rich valuations," he wrote in a report released on Friday titled "The U.S. Housing Bubble -- The case for a home-brewed hangover".
"Expectations of future house price appreciation are spectacularly, and unrealistically, high," he wrote.
Morris has doubts about the use of the quality-adjusted home price index. He thinks the existing stock of housing does not show the same improvement in quality as new homes.
Mark Weisbrot, co-director of the Center for Economic and Policy Research in Washington, DC, also thinks that there is a housing bubble. In his article "Greenspan Should Respond to Housing Bubble" on 24 June, he urges the Federal Reserve chairman Alan Greenspan to emulate Mervyn King, Governor of the Bank of England, who had sounded the warning in the UK that "the chances of falls in house prices are greater than they were".
"The bigger the housing bubble grows, the greater will be its negative impact on the economy when it bursts," writes Weisbrot.
"The Fed Chairman is supposed to be the country's most fearless economic watchdog, appointed to be independent of political pressures, willing to speak the truth and take the heat for 'pulling the punch bowl away just as the party is getting started.' If he won't warn the public of dangerous bubbles in asset prices, who will?"
Those who are familiar with Greenspan's thinking would know that he would probably not acknowledge a bubble even if it were staring at him in the face. Back in 2002, in defending his failure to act earlier to deflate the stock market bubble of the late 1990s, he had said that "it was very difficult to definitively identify a bubble until after the fact -- that is, when its bursting confirmed its existence".
Back in the late 1990s, Greenspan would have been concerned that any tightening action taken to deflate the stock bubble could also harm the economy. Unfortunately, the problem today could be worse. With American households more heavily indebted than ever, a housing bubble may be needed just to keep the US economy going.
As Richard Russell wrote in the Dow Theory Letters earlier this month: "I believe the Fed's fighting the global forces of DEFLATION. I think that Greenspan is afraid that the American consumer is 'tapped out.' And that consumers are very close to cutting back on their spending. The Fed's defense against a 'disastrous' consumer cut-back is to keep asset inflation going."
On 30 June, the Federal Reserve meets to discuss its next move in monetary policy. With near-unanimity among economists that the Federal Reserve will begin its tightening cycle at the meeting, we will soon know whether there is a housing bubble.
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