Where are house prices headed? Are house prices in the United States stretched to the limit? Are they really that much out of whack with the strength in local economies? Not really, according to past experience.

Author:Fratantoni, Michael
Position:Cover Report: Business Outlook

The rapid home-price appreciation of the last few years can be explained by the fundamentals of supply and demand. Shocking, we know, but the fundamentals are ... well, fundamental to house prices.



Low interest rates have led to above-trend appreciation at the national level. With respect to variations in home-price growth across regions, areas with strong population, income and employment growth and constraints on new supply are the areas that have seen the most rapid price growth. This article considers recent trends in U.S. house prices and provides an outlook regarding where house prices may be headed in the coming years.

Some analysts have been concerned that there is a bubble in the housing market--i.e., that prices have increased at an irrationally rapid rate, fueled by unrealistic expectations of ongoing appreciation. As a rule, we do not believe that prices have grown at an unreasonable rate given the underlying economic factors at work. As economic circumstances become less favorable, with interest rates rising and inventories of unsold homes increasing, we are forecasting a deceleration in home-price growth rates.

We forecast that home prices at the national level will increase at a 4 percent to 5 percent rate over the next several years, in line with longer-run historical averages but substantially below the appreciation rates experienced in recent years.

The U.S. housing market in a global perspective

In order to properly understand the recent dynamics in the housing markets, we need to review the evidence with respect to the economic fundamentals, both on the national and the local market levels. Interest rates are determined at the national or international level, while labor and housing markets tend to be more responsive to local conditions.


Over the past 30 years, house prices at the national level have grown at about a 6 percent annual rate. The year-over-year growth as of the third quarter of 2005 was 12.02 percent, according to the Office of Federal Housing Enterprise Oversight (OFHEO) (see Figure 1). Prices grew at an annualized 11.44 percent rate in that quarter.

Note that home prices have increased at double-digit rates at the same time that overall inflation rates have been quite low, with core inflation rates hovering around 2 percent in the last few years. This means that real home-price appreciation rates, controlling for the effects of inflation, have been even stronger than nominal rates in comparison with historical averages.

Are nominal or real house-price trends more important in this type of analysis? Traditional economic analysis emphasizes the important of real values, as these quantify the additional purchasing power of any home-price gains. However, it is likely that homeowners and other market participants respond at least partially to changes in nominal values, so we will focus on nominal values in this analysis.

How do these appreciation rates for the United States compare with those in the rest of the world? While nominal house prices in the United States grew 73 percent between 1997 and 2005, prices in the United Kingdom grew 154 percent over the same period; in Spain, 145 percent; in Ireland, 192 percent; in France, 87 percent; and in Australia, 114 percent (see Figure 2). And this was during a period in which population and gross domestic product (GDP) in the United States were growing at a more rapid rate than in these countries.

On a global basis, long-term interest rates have remained low in recent years, as central banks around the world have been increasingly successful in controlling inflation and inflationary expectations, and potentially due to a glut of savings on a global level. The low cost of financing has been a principal factor in propelling home prices higher worldwide.

Recently house prices in some countries have declined. Some analysts have indicated that the volatility these countries have experienced is a model for future developments in the U.S. housing markets. However, it is important to remember that size matters. Some of these countries, in economic terms, in geography and in population, are the size of individual states in the United States. The...

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