Jonathan McCarthy and Richard W. Peach of the New York Fed paint a relatively optimistic picture of the US’s housing market. From “Are Home Prices the Next Bubble?” FRBNY Economic Policy Review, Dec 2004:
- 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.
I have to admit that I’m somewhat surprised by the paper’s findings, particularly when it comes to the comparison of house prices to rental prices. The authors note that one of the main pieces of evidence of the housing price bubble (and the one that is most convincing to me personally) is that house prices have outstripped rents in recent years. However, they argue that the primary reason that this is so is because houses for sale have been increasing in quality faster than rental properties. When house prices are adjusted for the increases in quality in purchased homes, then the recent rise in house prices looks smaller and the ratio of house prices to rental prices has been pretty much constant over the past few years.
It’s a reasonable point. I’m not quite convinced, however. This argument suggests that people are essentially “consuming more house” (i.e. living in a nicer house) when they buy than they would if they rented. But isn’t it possible that that itself is a reflection of a housing market bubble? If people consume more house than they would otherwise simply because they expect the value of that house to rise (an assumption that I have no evidence for, but find plausible), then McCarthy and Peach’s dismissal of the evidence for a bubble is unwarranted.