A key risk facing the US economy this year is the deflation of the US housing boom. Whether or not it is a bubble has of course been subject to much debate. The Economist has long criticised Mr Greenspan for "inflating a housing bubble by holding interest rates low for so long". The OECD argue that some regions - especially California and Florida - suffer from "price overheating", but there is no housing bubble at the national level. (Dearieme commented "that must be a considerable consolation to everyone who's managed to buy a national house"). See also my previous posts.
But how best to detect and measure those local hotspots? HSBC economists Ian Morris and Ryan Wang recently published 110 page report, A Froth-Finding Mission: detecting US housing bubbles(Warning: 1.9Mb PDF), gets to the bottom of the issue. The report itself concludes that the "glass is half froth":
We suggest that about half of the US housing market is frothy and that this ‘bubble zone’ may be overvalued by as much as 35-40%, after taking into account low interest rates and tax advantages. Current valuations imply a large permanent reduction in the risk premium and/or a sizable step up in future capital gains, not all of which, we think, is justified. The ‘bubble zone’ accounts for 50% of US GDP, or over USD6trn, nearly the size of the German, French, and UK economies put together. In other words, it’s big. Therefore, when these housing bubbles begin to deflate, it is likely to have substantial macroeconomic consequences.
What’s troubling is that even a perfect ‘soft landing’ in the form of flat national house prices would be consistent with a 35-40% collapse in existing home sales. The gush of liquidity from mortgage equity withdrawal would dry up, resulting in a growth drag worth over 3% of GDP. If this adjustment can be managed over many years (and hopefully it will), the economy can avoid recession and get away with soft growth. If the process is squeezed into a shorter time frame instead, then recession is probable, forcing the Fed to once again consider unconventional policy options – a probability that would only rise if the money supply were to decline at the same time the ‘bubble zone’ deflates.
To my mind the HSBC report's analysis and conclusions are about right. There's no nation-wide bubble, but there is enough overheating in major parts of the United States for there to be serious downside growth risks should they burst.
I do not consider this to be the greatest threat facing the US or global economy. As I have argued before, the experience of both the Reserve Bank of Australian and Bank of England is that housing bubbles can successfully be deflated over a 2-3 year period by steady rate hikes and clear, consistent messages to investors. If the Federal Reserve is able to follow their example - and there's no obvious reason why they can't - that would detract around 1.0 to 1.5 percentage points a year from GDP growth. Enough to drag annual US growth below trend, but nowhere near recession territory.
What are the risks to such scenario? One is that the Fed could raise rates too aggressively. But I doubt that; they seem to be near the end of their tightening cycle. A greater risk is if a major crisis (banks or hedge funds collapse, avian flu pandemic, war with Iran) caused the Fed to pump massive liquidity into the finnacial system, giving the housing boom a second wind - and then followed that some months later with aggressive rate hikes. That might trigger a more rapid downward price spiral, rather than gentle price deflation. It's not my central scenario, but I would not rule it out.
By the way, the HSBC report is based on HomePulse, their new online US housing valuation model/spreadsheet:
It is an effective tool for evaluating the housing ‘bubble’ debate and we are making it available to clients. Access it at HSBC Home Pulse. Users can apply a wide array of valuation techniques to over 200 areas and aggregates, including all 50 states and 150 cities, and one can create customizable ‘bubble’ and ‘non-bubble’ zone aggregates. Assumptions for many variables, such as mortgage rates, can be changed, which is useful for scenario analysis. This will allow users to be better informed about the US housing bubble debate.
So all you 'bubble' types can develop your own house price scenarios and valuations!
P.S. For an earlier blog post on the HSBC report see Calculated Risk (and the 24 comments below).