Housing "Bubble" update
The comments that follow are from Scott Grannis, Chief Economist at Western Asset Management. (WAM has more than $125 billion under management!)
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OFHEO today released its house price index for the second quarter, and wow, it was a doozy. "There is no evidence here of prices topping out. On the contrary, house price inflation continues to accelerate. The robust appreciation rates are striking both in terms of their magnitude and in their geographic scope." But the report also opined that the appreciation rates "are likely unsustainable given the underlying inflation rate, income growth, and other factors."
As the chart shows, real housing prices are soaring. If my estimate of a 1% annual trend real appreciation is correct, then the average house is about 35% "overvalued." Prices have risen about 11% in real terms in just the past year. That is the fastest rate of real price appreciation since OFHEO began compiling the statistics in 1975.
Most observers correctly note various factors driving housing prices higher (e.g., low mortgage rates, low taxes, strong income growth, demographics, and building restrictions in many areas that limit the supply of new homes). One important factor that seems to me to be missing from most analyses is monetary policy. As evidenced by a falling dollar, rising gold, low real yields and rising commodity prices, monetary policy has been pretty easy (i.e., inflationary) for the past several years. Inflationary monetary policy should result in higher prices for all tangible assets, so if we accept that monetary policy has been accommodative then the housing bubble is not really a bubble (in the sense of being irrational) but a rational response to an unexpected policy action.
Following this logic, the housing market needs several things to happen before it cools off. Will taxes increase? Unlikely. Will mortgage rates rise significantly? Only if the Fed tightens massively and/or the bond market starts worrying about inflation. Will income growth slow significantly? No signs of that yet, in fact real personal income has been growing at a very healthy 3.5-4% rate for the past 18 months. The Katrina disaster shouldn't alter that materially. Will demographics change materially any time soon? Unlikely. Will local building restrictions be lifted all over the country? Unlikely. Will housing simply become unaffordable? It hasn't happened yet, and clever new mortgage instruments keep forestalling that eventuality. In fact, households' mortgage interest payments as a percent of disposable income have not increased at all since 1991 according to the Fed.
If the Fed were to continue raising rates by 25 bps at every meeting (an extremely unlikely event, according to the bond market), the real Fed funds rate might reach 4% by the end of next year. That would be undeniably tight, but that would not guarantee a reversal of the inflationary forces that are still driving the price of tangible assets higher. The real funds rate averaged about 4% for six years in the late 1990s before the economy succumbed and deflation started to rear its ugly head. Meanwhile, even if the Fed were to become scared of inflation, its ability to become aggressively tighter is increasingly limited by
1) The Katrina disaster, and
2) The fear that they might trigger a housing collapse that could severely impact the economy.
They are between a rock and a hard place, as the saying goes. And very tight money would probably not push mortgage rates up by much, which is another way of saying that the Fed's ability to cool the housing market by increasing short-term rates is limited. Those with ARMs are vulnerable, but that vulnerability will only start kicking in gradually over the next 18 months as resets begin to be triggered.
That still leaves the bond market, which could decide that inflation is more of a problem than expected. A decision by the Fed to pause, in deference to Katrina, might trigger such a response. If 10-year yields were to rise by at least 100 bps, refinancings would slow appreciably and the housing market might well begin to cool.
In any event, while prices obviously can't keep rising at anything near the current pace forever, a bursting of the housing bubble is not yet on the near-term horizon.
~~~~~~~~~~~~~~~~~~~~~~~~~~
OFHEO today released its house price index for the second quarter, and wow, it was a doozy. "There is no evidence here of prices topping out. On the contrary, house price inflation continues to accelerate. The robust appreciation rates are striking both in terms of their magnitude and in their geographic scope." But the report also opined that the appreciation rates "are likely unsustainable given the underlying inflation rate, income growth, and other factors."
As the chart shows, real housing prices are soaring. If my estimate of a 1% annual trend real appreciation is correct, then the average house is about 35% "overvalued." Prices have risen about 11% in real terms in just the past year. That is the fastest rate of real price appreciation since OFHEO began compiling the statistics in 1975.
Most observers correctly note various factors driving housing prices higher (e.g., low mortgage rates, low taxes, strong income growth, demographics, and building restrictions in many areas that limit the supply of new homes). One important factor that seems to me to be missing from most analyses is monetary policy. As evidenced by a falling dollar, rising gold, low real yields and rising commodity prices, monetary policy has been pretty easy (i.e., inflationary) for the past several years. Inflationary monetary policy should result in higher prices for all tangible assets, so if we accept that monetary policy has been accommodative then the housing bubble is not really a bubble (in the sense of being irrational) but a rational response to an unexpected policy action.
Following this logic, the housing market needs several things to happen before it cools off. Will taxes increase? Unlikely. Will mortgage rates rise significantly? Only if the Fed tightens massively and/or the bond market starts worrying about inflation. Will income growth slow significantly? No signs of that yet, in fact real personal income has been growing at a very healthy 3.5-4% rate for the past 18 months. The Katrina disaster shouldn't alter that materially. Will demographics change materially any time soon? Unlikely. Will local building restrictions be lifted all over the country? Unlikely. Will housing simply become unaffordable? It hasn't happened yet, and clever new mortgage instruments keep forestalling that eventuality. In fact, households' mortgage interest payments as a percent of disposable income have not increased at all since 1991 according to the Fed.
If the Fed were to continue raising rates by 25 bps at every meeting (an extremely unlikely event, according to the bond market), the real Fed funds rate might reach 4% by the end of next year. That would be undeniably tight, but that would not guarantee a reversal of the inflationary forces that are still driving the price of tangible assets higher. The real funds rate averaged about 4% for six years in the late 1990s before the economy succumbed and deflation started to rear its ugly head. Meanwhile, even if the Fed were to become scared of inflation, its ability to become aggressively tighter is increasingly limited by
1) The Katrina disaster, and
2) The fear that they might trigger a housing collapse that could severely impact the economy.
They are between a rock and a hard place, as the saying goes. And very tight money would probably not push mortgage rates up by much, which is another way of saying that the Fed's ability to cool the housing market by increasing short-term rates is limited. Those with ARMs are vulnerable, but that vulnerability will only start kicking in gradually over the next 18 months as resets begin to be triggered.
That still leaves the bond market, which could decide that inflation is more of a problem than expected. A decision by the Fed to pause, in deference to Katrina, might trigger such a response. If 10-year yields were to rise by at least 100 bps, refinancings would slow appreciably and the housing market might well begin to cool.
In any event, while prices obviously can't keep rising at anything near the current pace forever, a bursting of the housing bubble is not yet on the near-term horizon.
posted by David M Gordon | 6:13 PM
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