By David F. Seiders. The U.S. economy would now be in recession without strong support from the housing sector. Rising home prices have been key to housing's support of the economy, energizing investment demand among prospective home buyers and generating massive amounts of housing equity that have been tapped by millions of homeowners for spending on a variety of consumer goods.

There now is speculation in the media about a bubble in house prices that could burst, a la the stock market, loading the last straw on an economy that's teetering on the edge of recession. Indeed, Forbes magazine recently asked "What if Housing Crashed?" and the answer wasn't pretty. Fortunately, this kind of story is based on faulty analysis of how the housing market really works.

Home price determination

Housing has both short- and long-term price determinants. At any moment, prices in a particular market are determined by the supply of housing units (new and existing) being offered for sale and the demand for housing units. If demand strengthens (e.g., due to falling mortgage rates), upward pressure will be put on prices, encouraging more housing production in that area.

It's important to remember that, by their nature, existing housing units can't be shifted from place to place as the geographical pattern of demand shifts around, and this fact limits the speed of the supply response to any shift in demand. It's also important to remember that housing units are not just investments, since houses provide a stream of services that households really want and need. Thus, people don't ordinarily unload their houses onto the market (and shift to rental accommodations) if they become concerned about the future course of prices. This fact forestalls the kinds of downward price spirals found in markets for financial assets.

Over the long term, prices of both new and existing homes must gravitate toward the replacement cost of housing. In this regard, it's important to note that a major component of replacement cost is the cost of producing lots. This cost, in turn, is determined largely by land-use policies in local markets that either encourage or discourage residential development.

What's been happening?

The demand for single-family homes definitely has been strong, builders have been hard-pressed to meet demand in many areas, and house prices have been subject to upward pressure as a result. But demand has been driven primarily by factors that don't lead to speculative price bubbles that are subject to deflation down the line.

The key drivers of demand recently have been strong household growth, strong growth in household income, low mortgage interest rates and strong investment demand stimulated by rising home prices.

It's true that this type of investment demand can create upward price movements that may be difficult to sustain down the line. But the importance of this factor is a relatively recent phenomenon (about a year). Furthermore, any prospective weakening of the investment demand is unlikely to produce significant downward movements in house prices, in view of the realities of house price determination in the short term.

It's also worth stressing that upward house price movements in recent years have been fueled from the supply side of the market by long-term upward pressures on the cost of building lots. Indeed, geographic areas that have shown the most rapid rates of house price appreciation generally are those where no-growth or slow-growth initiatives have seriously limited the supply of land for residential development. These long-term cost pressures are not going to go away.

Looking ahead

Recent rates of house price appreciation may not be sustained during the next year or so, but outright price declines will be rare. Look for national house price growth on the order of 5 percent, down from 8 percent or more in recent quarters but still quite good on a longer-term basis.