THE FEDERAL RESERVE IS BEING ROUNDLY chastised in some circles for keeping interest rates too low for too long, on the grounds that the Fed is feeding house price bubbles that will burst when interest rates eventually rise. These pundits argue that the Fed should raise rates immediately, accepting some short-term costs to the economy while avoiding a potential economic disaster down the line.

There's no question that house price appreciation has been outpacing overall inflation in the U.S. economy. It's also true that ratios of house prices to income, and ratios of house prices to rent, have risen substantially. These three measures frequently are cited as evidence that house prices have bubbled out of control and are poised for collapse.

Still Better To Buy In fact, there's no necessary relationship between house prices and overall inflation. Furthermore, comparisons to household income and market rents should focus on mortgage payments rather than on house prices, and on this basis homes still are highly affordable as well as cheap relative to renting in most areas.

In places where house prices have risen most aggressively and have created bona fide affordability problems, serious constraints on the supply of buildable land have been the culprit. Land-use constraints are likely to tighten rather than loosen, as persistent growth in the number of households presses against limited land supply.

Historically low interest rates certainly have bolstered housing price pressures. The low rates have effectively maintained both affordability and the competitive position of ownership over renting in most areas.

“Aye, there's the rub,” say the bubble theorists. If interest rates have held it all together so far, rising interest rates will weaken buyer demand as well as house prices. Why not stop the upward price spiral sooner rather than later? Have the Federal Reserve pull the trigger now, they say.

WHAT TO DO? The Fed is patiently trying to nurse the U.S. economy back to health and simply will not raise rates to weaken house prices. The Fed has said that interest rates eventually will have to rise, but our central bank will proceed very cautiously; indeed, the NAHB's forecast places the first rate hike in January 2005.

Furthermore, a delayed and gradual monetary tightening process will be occurring in an environment of stronger employment and household income growth. History clearly shows that house prices will not fall when these “real” economic fundamentals are strengthening.

Rates of house price appreciation are likely to recede to some degree on a national basis but the chances for outright price declines are negligible. As the Fed snugs up monetary policy and mortgage rates firm up gradually over time, house price appreciation will gravitate toward the rate of growth of per capita income in places where the supply of buildable land keeps pace with housing demand. Where land-use constraints are severe, house price appreciation may continue to outpace income growth even as interest rates rise.

Chief Economist, NAHB Washington, D.C.