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House Prices: Is the Fed Making the Same Mistake Again?

Wednesday, October 9, 2013

House price data indicate that the painful readjustment process is complete. It is time for the Fed to stop manipulating prices.

More than seven years after the bubble peak in U.S. house prices, and four years after suffering the 2007-09 price collapse, American house prices are now recovering and indeed rising rapidly. The average house price went up over 12 percent from July 2012 to July 2013, according to the S&P/Case-Shiller house price index. There has even been talk of new house price bubbles. But where are current prices when put in historical context and what does this mean for future Fed actions?

First, let us measure average U.S. house prices in inflation-adjusted (real) terms so we are not fooled by the constant depreciation of the dollar. Figure 1 shows house price history since the mid-1990s in inflation-adjusted terms, displaying the Case-Shiller index in constant 1996 dollars.

Figure 1

Pollock figure 1

Adjusted for inflation, we can see that house prices had their amazing bubble run-up, then fell for six years, from the end of 2005 until early 2012. Since then, they have gone back up by 15 percent, which is a lot in real terms. That level is still 34 percent below the peak, but we don’t want the distortions of another bubble peak!

The Fed should stop trying to stoke house prices further and turn off its unprecedented allocation of central bank credit to mortgages.

Figure 1 also shows that the current real price level is equal to that of 2001. After the bounce of the last several quarters, in real terms, homeowners are on average back to where they were 12 years ago, which is not too bad all things considered. In 2001, real house prices were rather high and significantly rising, but they had not yet reached extreme price inflation. The Federal Reserve was rapidly lowering interest rates then, hoping for a “wealth effect” from houses to offset the shriveling of the tech stock bubble. Of course, they got more housing “wealth” than they bargained for. Will they again? 

At present, the Fed is still keeping short-term interest rates near zero and manipulating long-term mortgage rates down through massive and unprecedented purchases of mortgage-backed securities for their own balance sheet — again to support house prices and again hoping for a wealth effect to offset the continuing drag of the shriveling of the previous bubble. Should the Fed continue to try to manipulate house prices higher from this point, as it did in 2001, or not?

To answer this, let us put house prices and inflation in long-term context, as Figure 2 does for the years from 1953 to 2013. Figure 2 shows the paths of the Consumer Price Index and average U.S. house prices over 60 years, both indexed to 1953=100.

Figure 2

Pollock figure 2

There is obviously a very close correlation between general inflation and nominal house prices, and real house prices on average rise little if at all over the long term. The housing bubble was a remarkable anomaly from the historical pattern, but note well that the housing shrivel took prices right back to the long-term inflation line by 2012. At the moment, however, they are headed back north of that line, with lots of financial inducement from the Fed.

Let us look at the same data in a different way in Figure 3, which displays the percent deviation of the nominal U.S. house price index from the increase in the Consumer Price Index over the same 60 years, again both set to 1953=100.

Figure 3

Pollock figure 3

The trend in this relationship is close to zero for most of the time, with the deviation varying between plus or minus 10 percent until 2000. Then the bubble took it to over 70 percent, the shrivel took it back to zero, and now the deviation is already higher than its pre-bubble 10 percent peak and is rising.

Conclusion: the house price adjustment from the bubble is already complete or more than complete. The Fed should stop trying to stoke house prices further and turn off its unprecedented allocation of central bank credit to mortgages.

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

FURTHER READING: Pollock also writes “Big Bureaucracy: The CFPB Turns 2” and “No, Virginia, Nothing Is Really Risk Free.” Arnold Kling contributes “Your Mortgage, Their Rent” and “Skin in the Housing Game.” Edward Pinto says “Let's Not Repeat the Same Mistakes that Led to the Housing Bubble” and “FHA Accepts Bailout.” James Pethokoukis argues “Of Course Americans are Better Today than 30 Years Ago” while asking “Are Bill Clinton’s Housing Policies Really Going to Get Off Scot-Free for Contributing to the Housing Bubble?

Image by Dianna Ingram / Bergman Group

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