Ever since the stock market began to unravel back in 2000, theories of unsustainable bubbles in house prices have littered the financial print and broadcast media. But house prices continued to rise at a healthy pace in virtually all parts of the country through the recession of 2001, as well as during the two years of job-losing economic recovery that followed.

The economic recovery shifted into a higher gear in the fall of 2003, generating meaningful increases in employment and provoking rebounds in consumer confidence in the process. Based on historical experience, those are developments that should push lingering concerns about house price declines to the sidelines. But the bubble theorists are not about to give up; indeed, there's just been a change in tactics. We're now supposed to believe that interest rates will shoot up this year and burst house price bubbles as the economic expansion proceeds.

A surge in mortgage interest rates, with everything else equal, certainly could weaken housing demand as well as house price appreciation. But an interest rate surge is unlikely this year, and everything else definitely won't be equal.

Whither interest rates?

Interest rates may gravitate upward in 2004, but the starting points are extraordinarily low and the increases are likely to be quite limited. For one thing, the Federal Reserve figures to keep short-term rates at historically low levels for most of the year, anchoring rates on adjustable-rate mortgages (ARMs) and holding down the entire rate structure.

Long-term rates are likely to move upward in advance of the Fed's first hike in short-term rates, as investors witness the strengthening expansion and begin to anticipate the Fed's first move. But extremely low inflation rates will keep a lid on long-term interest rates for some time, and the NAHB anticipates less than a percentage point rise in fixed-rate mortgage yields over the course of the year.

In the unlikely event that market psychology drives long-term rates even higher, an effective ARM "safety valve" will blunt the impacts on housing demand and house prices as buyers shift to shorter-term mortgage instruments.

All things are not equal

Interest rates do not go up in a vacuum, and upward rate pressures in 2004 will occur in an environment of strengthening growth in employment and household income--factors that serve to strengthen housing demand. As Fed chairman Alan Greenspan has suggested, a combination of modestly higher interest rates and stronger job and income growth should have little net effect on the demand for homes and should not provoke weakness in house prices.

House price increases in recent years have primarily reflected increases in the prices of residential lots rather than increases in the costs of producing the structures. In an era of progressively tightening land-use constraints and associated limits on the supply of buildable land, there will be persistent increases in lot prices that will keep upward pressure on house prices, particularly in areas with severe lot shortages. After all, prices of every home in a market must gravitate toward its replacement cost--including the cost of finished lots.