HOUSE PRICE GROWTH ACCELERATED AS THE economy surged to a cyclical peak in 2001 and then subsided through the fall of last year. But prices have spurted since then, resurrecting strident charges of price bubbles in U.S. housing markets.

The Facts House prices have been moving up aggressively since last fall, especially in metro markets along the coasts where housing demand is strong and land is in particularly short supply. The national average house price increase approached 10 percent around mid-2004, and increases of 20 percent or more were recorded in various metro areas in California, Nevada, and Florida.

It's true that the most popular measures of house price change (repeat-sales measures) are subject to some upward bias, particularly when the residential remodeling market is going great guns—as it has since the late 1990s. But there's no getting around the fact that house price growth has rebounded into a truly impressive zone, even after correcting changes in the size and quality of homes over time.

Bubble Evidence? Several major media outlets recently have paraded two pieces of evidence past readers: ratios of house prices to household income and ratios of house prices to rents. Both of these ratios have risen dramatically in recent times, supposedly signaling bubble conditions.

The major flaw in this type of analysis is failure to account for the dramatic influence of interest rate changes. Indeed, analysis of ratios of monthly mortgage payments to household incomes and of monthly mortgage payments to monthly rents shows that the affordability of home buying has been very well maintained and that the cost of owning a home has remained low relative to the cost of renting. Why else would the nation's homeownership rate be soaring to increasingly higher records?

Interest Rate Quandary? “Aye, there's the rub,” say the bubble theorists. If low interest rates have fueled housing demand and house prices while maintaining housing affordability as well as the advantages of owning over renting, what happens when the interest rate structure inevitably moves upward?

The outcome will depend on how much—and how quickly—interest rates move up as well as on how growth of employment and household income perform in the process. Most major forecasts (including the NAHB's) show orderly and gradual interest rate increases, including a “measured” process of monetary tightening by the Federal Reserve, along with strengthening job and income growth. As Fed Chairman Alan Greenspan has said several times, the net impact of these developments on housing demand (and prices) is not likely to be serious.

Bottom Lines It is likely that rates of house price appreciation will slow in many places during the next year, but outright declines will be extremely rare. Builders should continue to mine the housing finance system for all it's worth as interest rates rise, getting as much mileage as possible from adjustable-rate loans—particularly in markets beset by severe land-use constraints.

David F. Seiders
Chief Economist, NAHB Washington, D.C.