Policy Today magazine cover
November 2, 2005

No one denies that the U.S. housing market has been red-hot for several years. But here does the Federal Reserve come down on the issue of a possible "housing bubble"?

As Princeton Professor Benjamin Bernanke prepares to step into Alan Greenspan's storied shoes, he is undoubtedly aware that he will also inherit the legacy of Greenspan's largely successful two-decade run as the nation's central banker. But as the Federal Reserve chairman approaches retirement at the end of January 2006, it appears that the nation's hot housing market—an over-inflated "bubble" some would describe it—might pose a threat to his legacy, not to mention the overall economy. After all, the bursting of the stock market bubble in 2000 helped contribute to a subsequent recession in 2001.

And no one wants a replay of that scenario—least of all the Fed—especially since critics contend that Greenspan & Co. should have tried harder to prevent stock prices from getting so out of whack with basic economic fundamentals, either by talking stocks down with more "irrational exuberance" type commentary or by raising interest rates to slow the economy and chill rampant speculation. The stock market bubble, argues Morgan Stanley economist Stephen Roach, was "Greenspan's most egregious policy blunder—failing to use the tools of monetary policy to nip the first bubble in the bud back in the late 1990s."

Now Roach and many other Fed watchers are fretting about Bubble II, though this time around the inflated asset looks to be housing rather than equities. Their fears are hardly unfounded. Any way you slice the data, it shows that home prices have been booming in recent years. Between 1975 and 1995, according to analysis by the Federal Reserve Bank of New York, real single-family house prices in the United States increased an average of 0.5% per year, or 10% over the course of two decades. By contrast, from 1995 to 2004, national real house prices grew 3.6% per year, a more than seven-fold increase in the annual rate of real appreciation, and totaling nearly 40% in one decade.

And it's not just that prices have surged; it's that they have surged relative to historical measures. Janet Yellen, president of the San Francisco Fed does the math this way. She looks at the ratio of housing prices to rents. When the price-to-rent ratio is high, housing prices tend to grow more slowly or even drift lower for a time. When the ratio is low, prices tend to shoot up. Currently, as she explained in a speech last month in London, the ratio in the United States is higher than at any time since data became available in 1970-about 25 percent above its long-run average.

But do big price jumps necessarily mean the nation has been enveloped by a giant bubble that's now ready to pop? Not quite, says noted economist Bruce Bartlett, formerly of the National Center for Policy Analysis. "This is really a coastal phenomenon," he observes. "That is where you have the really significant increases. I worry about the situation in California, in particular."

A study by National City Bank examined 25 years of data for 99 metropolitan areas—taking into account population density, income levels, interest rates and how price levels in different areas compared to one another in the past—to arrive at a "fair value" for each area. The study concluded that 27 of the markets are overvalued, 29 are undervalued and 43 are fairly valued, meaning prices are within 10% either way of their fair value. Of those overvalued markets, eight of the top ten were in California.

Yet many metro areas were within shooting distance of fair value. Boston, for instance, was 14% above fair value, Chicago, 11% and Washington, D.C., 10%. Even New York wasn't completely out of line at 16% over value. Overall, the study paints a picture of a hot national housing market with pockets of white-hot activity. And that's pretty much how Greenspan sees it. In a speech last May to the Economic Club of New York, he said the housing market showed "a little froth" and while he didn't think there was a national bubble, "it's hard not to see that there are lots of local bubbles." Bernanke expressed a similar view last summer as chairman of the White House's Council of Economic Advisers. "While speculative behavior appears to be surfacing in some local markets, strong economic fundamentals are contributing importantly to the housing boom."

What's behind the big upward move in housing prices? One factor may be the anemic stock market where the major indexes are still far below their peak prices of 2000. With lackluster returns coming from financial assets, real assets like housing and land have looked more attractive.
But certainly low mortgage interest rates are the biggest factor, reflecting the Fed's success over
the years in fighting inflation (Demand by central Asian banks for U.S. debt hasn't hurt either.)
In addition, the Fed cut short-term interest rates from 6.5% in May 2000 1995 to a low of
1% in June 2003. And even after 11 straight rate hikes since 2003, short rates are still a skimpy 3.75%. But clearly there is a speculative element at play as well.

Stories abound about people buying second homes with the intention of flipping them for a profit a year or less later. With interest rates and inflation having been so low for so long, there is an expectation that such a benign environment is a more or less permanent economic fixture, and thus housing prices are in no jeopardy of imminent decline. As Greenspan said in a September speech, "Success at stabilization carries its own risks. Monetary policy-in fact, all economic policy-to the extent that it is successful over a prolonged period, will reduce…perceived credit risk."

So what happens next? Neither Greenspan nor Bernanke believe it's the job of monetary policy to deal with bubbles, whether they are in the stock market or the housing market. (Bernanke believes in targeting inflation, not asset prices.) There's always the risk of making things worse, however. Instead of deflating a bubble, you pop it and send the economy into a deep recession. Instead, Greenspan has been an advocate of letting market forces run their course—which may not be such a bad idea.

According to a study by the Federal Deposit Insurance Corporation, most real estate booms in the past were followed by periods where prices rose slowly rather than collapsed. This allowed other economic factors-including household income and housing supply—to catch up. Furthermore, when markets did go bust—as in the mid-1980s in Houston and other oil patch markets when oil prices collapsed—the local economy was already under pressure and shedding jobs.

Says economist Mark Zandi of Economy.com, "I think the most likely scenario is that housing will cool and some bubbles will burst." Indeed, there's growing evidence that it's already happening. For instance, the average sales price in Manhattan fell almost 13% in the third quarter vs. the second quarter, according to Miller Samuel, an appraisal firm. Or take Ann Arbor, Michigan, where the median sale price of a home was $227,500 in August compared to $230,000 a year earlier. It appears that Greenspan—"The Maestro"—might go out on a high note after all. And barring any bursting bubbles, Bernanke appears likely to follow the same score.


About James Pethokoukis

James Pethokoukis is a senior writer for US News and World Report.