Huffington Post: Housing still heading south

April 28, 2008

Tell you something you don’t already know, right? Though the conclusion has been stated often enough, it’s nice to see data to back up the story. For that, check out Hale Stewart’s latest article over at Huffington Post (via Patrick).

It includes the Case Shiller chart showing the run-up in house prices over the last few years. The chart is similar to the NAR chart I reproduced in a post last week, though it doesn’t juxtapose prices with median income.

Like I said last week, the path of house prices will definitely have plenty to do with interest rates. Homes remain overvalued relative to income, but with mortgage rates still near historic lows, folks that CAN get financing are still able to pay up for houses.

[Recall the math from last week: With a fixed rate 30-year mortgage of 18%, a $2000 monthly payment will buy $132,000 worth of home. Cut the interest rate to 6% and the same $2000 payment will buy $334,000 worth of home. Low interest rates support higher house prices.]

And since the threat facing the economy may be Japan-style deflation rather than U.S.-style stagflation, interest rates are likely to stay low for some time….

As credit dries up so does the money supply, leading to deflation. To fight that, the Bernanke Fed has to encourage more borrowing. With lower interest rates, of course, borrowers are encouraged to take on more debt.

But the risk of low interest rates is that the dollar will continue to lose value. Lots of smart people are arguing that rising energy and food prices aren’t the result of inflation so much as they’re the subject of the latest speculative bubble. Holding dollars isn’t very appealing at 2% interest so people are investing in hot commodities.

And so we arrive at Bernanke’s paradox. To save the banking system and avoid deflation, Bernanke has to maintain low interest rates….but that risks runaway inflation later on as low-yield dollar-denominated assets are punted en masse.

If inflation does jump (higher than the too high 5% annually at present), then the Fed will have no choice but to raise rates to protect the dollar. Besides pushing the economy into a steep recession, that could drive house prices so low that today’s pessimistic estimates will look like tomorrow’s optimistic estimates.

Summing up: over the next year house prices will continue to fall, but due to low rates they may not fall as far as some have suggested. Looking further out, though, the Fed’s low interest policy is likely to spur inflation, forcing the Fed to pull a 180 and raise rates…hammering home prices.

The moral of the story is not to be fooled into buying a house too early if prices level off around current levels.

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