John Makin of The American Enterprise Institute gives his views on how the housing market downturn might get started and how quickly housing prices might fall once the downturn begins. His message to the Fed is to be very, very careful because the measured path is treacherous:
The Energy in Real Estate, By John Makin, Wall Street Journal Editorial: America's economy is heavily dependent on a housing boom to offset the substantial drag on growth arising from the doubling of oil prices since spring 2004. Meanwhile, the Fed's steady rate increases, now expected to boost short-term rates above 4% by early next year, will at least slow, and perhaps reverse, the sharp rise in housing prices -- just as the Bank of England's modest 125-basis point tightening did in 2003-4. The U.K. experienced a sharp drop in consumption and growth shortly after housing began to falter. The Fed will need to engineer a carefully modulated tightening to avoid the same fate for the U.S.
The record of central banks in quelling housing bubbles over the past 15 years is not encouraging. In fact, discussions today of real estate markets in New York, L.A., Las Vegas, Miami, and other cities remind me of the stories I was hearing when I lived in Tokyo in 1988-89. … Of course, there are differences between Japan's real estate boom 15 years ago and that in the U.S. today. Japan's banking system became heavily exposed to real estate investments, especially as land prices shot up. Today, American banks are less exposed to the real estate bubble, …. It is American households that are primarily exposed to a collapse of the real estate bubble in the U.S.
Today's U.S. real estate bubble is a crucial ingredient in sustaining global demand growth for two reasons. First, demand growth is weak outside the U.S., in Europe, the U.K., China and emerging Asia. Japan has seen a modest increase in growth of domestic demand as real wages have ceased falling after a decade of weakness, but this is not sufficient to sustain global demand growth. The second and most important reason for the crucial role of the U.S. real estate bubble is that it is offsetting the drag from higher oil prices on U.S. growth. … How vulnerable is U.S. growth to the real estate bubble? While the bubble is heavily concentrated in metropolitan areas, overall rising real estate values have contributed massively to household wealth and even to disposable income as the innovative mortgage sector arranges for easy withdrawal of rising equity in homes. The existence of a bubble in major metropolitan areas is not in doubt. The ratio of home prices to incomes is two to three standard deviations above the average since 1980 in over 20 major cities … The tension in the U.S. housing sector is rising, as it did in Japan after 1989 and in the U.K. last year, because the central bank is raising interest rates. ... So far, the impact of Fed tightening on the real estate sector has been limited to sporadic signs of slower price increases in some markets. This is partly because even though the Fed has raised short-term interest rates, long-term interest rates are actually lower than they were a year ago -- the famous Greenspan "conundrum."
That said, the sharp rise in short-term interest rates makes it more difficult to arrange effective low "teaser rates" that attract more spending on real estate by increasing affordability. With short-term rates rising and housing prices having risen by another 20%, affordability is becoming an increasing problem at the margin …
The contribution of the U.S. real estate boom to household consumption and U.S. demand growth, not to mention the U.S. construction industry, can be sharply curtailed even if price increases just drop from the current 20%-plus level to 5% or below, much as they have done in the U.K. Falling house prices are not required for housing to become a drag on growth. … Once the momentum for ever-rising prices is lost and house prices actually begin to level off, the desired stock of housing falls. Then, construction activity ceases and the rush of speculators to purchase more real estate evaporates and turns into a desire to sell. If the process is orderly, housing price inflation just falls toward zero. If it is disorderly, as was the case in Japan by 1991, house and real estate prices collapse as panicky speculators, unable to service their mortgages because of falling rents and less ability to obtain loans, start dumping properties. A mere leveling of housing prices (a probable event in the coming year) would be sufficient to remove the boost from housing that is worth about 1 percentage point of growth. With that impetus eliminated and the drag from higher oil prices continuing, the U.S. growth rate could easily drop to 2.5% or lower, depending upon the future path of energy prices, the persistence of the negative impact of past energy price increases, and the sharpness of the drop in house prices. … The notion that world growth is sustainable given oil at $65 a barrel because the U.S. can shrug off the implied energy drag depends almost entirely on a continued U.S. housing boom. Yet the Fed is raising interest rates, a policy move that has already quelled the housing boom in the U.K., Australia and New Zealand as it did in Japan 15 years ago. There are signs of cooling emerging already in some of the "hot" U.S. housing markets as inventories of unsold house build and rents slip on speculative properties. The Fed needs to keep moving cautiously on tightening over the year because the housing slowdown will probably arrive suddenly as speculative sentiment dies. Further, the drag from higher energy prices has risen sharply in recent weeks. It remains to be seen whether the final, delicate phase of such a tightening will be administered by Mr. Greenspan or his successor. President Bush will no doubt be very interested to hear from prospective Fed chairmen their plans for executing such a tricky monetary maneuver.