Real-time market monitoring reveals signs of a brewing housing bubble in the US


National

Jarrod Coulter, Valerie Grossman, Enrique Martinez Garcia, Peter C.P. Phillips, Shopping Shi

March 29, 2022

Real home prices — prices adjusted for inflation — have risen steadily in the United States since 2012. The pace of home price increases began to accelerate further before the pandemic, but have strengthened significantly since early 2020.

For potential buyers and sellers as well as policy makers, knowing the state of housing markets is imperative. Using a new statistical toolkit to assess the health of the US housing market in real time, we argue that the underlying causes of the rise differ from those that occurred during the recent housing boom, which preceded the 2007-2009 global financial crisis. However, there is a growing concern that US home prices are once again becoming detached from fundamentals.

Monitor the emergence of housing bubbles in real time

The asset – in this case, housing – is in the initial expansionary phase of a bubble when price increases are inconsistent with market fundamentals. A rapid rise in real home prices, such as the one we are observing now, does not in and of itself indicate a bubble. Shifts in disposable income, cost and access to credit, supply disruption, rising costs of labor and building raw materials are among the economic reasons for sustainable gains in real home prices.

But real home prices can differ from market fundamentals when there is a widespread belief that today’s strong price increases will continue. If many buyers share this belief, purchases arising from “fear of missing out” can raise prices and raise expectations of strong home price gains.

This self-actualization mechanism leads to price growth that may become exponential (or explosive), gradually deviating the housing market from fundamentals until investors become cautious, policy makers intervene, the flow of money into housing dries up and a housing correction occurs or even a bust occurs.

Exploding expectations (often called exuberance) in real home prices lead to many outcomes, including misallocation of economic resources, distorted investment patterns, individual bankruptcies, and broad macroeconomic effects on growth and employment. Monitoring the housing market in real time for such price spikes can help investors and policymakers to respond before the anomalies become so severe that subsequent corrections trigger economic disruption.

Real home price time series that contain rings of bubbles that are driven by expectations exhibit two important properties – they are non-linear when plotted for being explosive during the boom (or abundance) phase, and they lead to a correction or even a crash if the market crashes.

To provide market diagnostics, the Federal Reserve Board of Dallas’ International Home Price Database team, in partnership with a network of scientists from around the world collaborating under the International Housing Observatory, produces data sets and statistics that characterize the potential glut in the market. The methodology uses new statistical methods to constantly monitor housing markets – in the United States and around the world – to detect symptoms and indicate the presence of emerging housing booms.

Signs of a turning point in the market

When the statistics derived from these methods are important, the time periods are stamped to denote abundance – prices are growing at an exponential rate beyond what is justified by economic fundamentals. The indicators are calculated every three months. A test result that exceeds the 95 percent threshold indicates 95 percent confidence in abnormal explosive behavior, or housing market fever.

The history of the US abundance index against the 95 percent threshold is shown in Chart 1. The statistic plotted in the lower panel provides a market temperature reading, such as that obtained from a personal thermometer. The abundance index shows the temperature, and the upper bound for confidence is the anomaly threshold. The current reading indicates that the US housing market has shown signs of abundance for more than five consecutive quarters through the third quarter of 2021.

Chart 1: As US real home prices soar, signs of exuberance appear

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The United States is not alone in the housing market fever. Fourteen of the 25 countries in the Dallas Federal Reserve Board’s International House Price Database show signs of a true home price glut.

A Diagnostic Approach to US Housing Markets

To assess home prices in the United States during the pandemic, we first develop an empirical relationship between home prices and those economic fundamentals underpinning the market, based on data up to the fourth quarter of 2019. The theoretical criterion is the baseline value of housing based on total future discounted rents. This is similar to the financing principle that the basic value of a company’s stock is the outflow of future dividends discounted at the cost of capital. (Similarly, here the company is a house, and its profits are rents discounted at interest rates.)

Working from this standard, the home-price-to-rent ratio is explained by a small set of lagging economic variables, such as an individual’s disposable personal income, housing rents, and long-term interest rates. The regression residual is evaluated, after removing the effects of the baselines, for any remaining evidence of explosive behaviour. Bottom line: Since the start of 2020, the price-to-rent ratio has risen beyond what observed fundamentals alone can explain (Chart 2).

Chart 2: The price-to-rent ratio quickly varies from basics

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The gap between the actual price-to-rent ratio in the United States has grown rapidly during the pandemic — compared to the period before the recent housing boom — and is starting to show signs of glut in 2021. GREAT Stats confirm that recent increases are far from normal.

Another important long-term pillar – directly related to the affordability of housing – is the ratio of house prices to disposable income. Chart 3 shows the dates of abundance episodes for this measure of housing affordability. This data – in contrast to previous metrics – does not yet show evidence of an explosion in the third quarter of 2021. But a rapid increase in the statistic near the bottom line through 2021 suggests that US real home prices may soon become unrelated to personal income Available per capita.

Chart 3: The price-to-income ratio is increasing rapidly, but not abundant

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The delay in the rise in this abundance statistic is partly due to the increase in real disposable income during the pandemic that has led to slower growth rates in the price-to-income ratio. The increase in disposable income is mostly related to the fiscal and monetary stimulus efforts associated with the pandemic and lower household consumption caused by movement restrictions and lockdowns.

If increases in disposable income turn out to be fleeting — as fiscal stimulus wanes and the Federal Reserve reverses accommodative monetary policy — recent patterns in the price-to-income ratio may prove a less useful measure of housing affordability. These temporary increases in disposable income are not a strong determinant of long-term housing investment. Thus, the price-income ratio metric alone may produce very conservative results when identifying housing market bubbles.

Another US housing bubble brewing?

Our evidence points to abnormal behavior in the US housing market for the first time since the boom of the early 2000s. Reasons for concern are evident in some economic indicators – the price-to-rent ratio, in particular, and the price-income ratio – which are showing signs that home prices in 2021 look increasingly far from fundamental.

While historically low interest rates are a factor, they do not fully explain housing market developments. Other drivers have played a role, including US fiscal stimulus programs related to the pandemic, supply chain disruptions linked to COVID-19, and associated policy responses. The resulting mainly-driven home price hike may have fueled the wave of panic fear from exuberance involving new investors and more aggressive speculation among existing investors.

Based on current evidence, there is no expectation that the repercussions of the housing correction will be comparable to the 2007-2009 global financial crisis in terms of scale or macroeconomic severity. Among other things, household balance sheets are showing better, and excessive borrowing does not appear to be fueling the housing market boom.

Importantly, the experience from the housing bubble in the early 2000s and the subsequent development of advanced tools for early detection and dissemination of warning indicators—some of which are illustrated in this analysis—means that market participants, banks, policy makers, and regulators are all better equipped to assess in Real time relevance of the housing boom. Thus, they are in a more informed position to respond quickly and avoid the negative and more serious consequences of a housing correction.



About the authors

Jarrod Coulter

Coulter is a research analyst in the research division of the Federal Reserve Bank of Dallas.

Valerie Grossman

Grossman is a researcher and director of web content in the research division of the Federal Reserve Bank of Dallas.

Enrique Martinez Garcia

Martínez-García is a senior research economist and advisor in the Research Division of the Federal Reserve Bank of Dallas.

Peter CP Phillips

Phillips is Professor Emeritus of Sterling at Yale University and Distinguished Professor at the University of Auckland.

Shuping Shi

Shi is Professor of Economics at Macquarie University in Sydney, Australia.

The opinions expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

real estate, monetary policy, economic conditions, COVID

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