Beyond the Bubble

An increasing number of economists and strategists on Wall Street expect the recent cooling in home sales to turn into an outright freeze in the residential real estate market. Data showing that median home prices of existing one-family homes rose 16.6% in October from a year earlier, the fastest pace since 1979, only reinforced the view that an unsustainable boom is likely to end in tears. The working hypothesis is that the undertow from a softening residential real-estate sector will eventually weaken national home prices and pressure household asset values. The reverse wealth effect that would ensue is expected to cut into consumer spending and severely weaken -- if not end -- the current U.S. economic expansion.

But despite the dire warnings to the contrary, a deceleration in national home price appreciation (which is likely) will not necessarily lead to a slump in nationwide home prices or the negative externalities associated with it. While certain regional real-estate markets could indeed be out of whack with the fundamentals -- and thus experience price declines -- this does not appear to be a nationwide phenomenon.

Home prices have been rising faster than incomes, but the ratio between average home prices and incomes remains below historical averages. Similarly, the ratio between total capitalization of household real estate relative to capitalized incomes (i.e., incomes adjusted for long-term interest rates) also remains below historical averages. Of course, this is no guarantee that home prices will continue to appreciate rapidly. It does suggest, however, that a broad-based decline in median or average home prices, which would be a threat to the growth outlook, remains unlikely.

The two-decade decline in homeowner equity as a fraction of household real estate continues to be a major concern, but the Fed's Flow of Funds data shows that homeowner equity as a fraction of household real estate stood at 56.8% during the second quarter. This is essentially in line with the 57% ratio that prevailed during 1997, a year in which a drop in the tax rate on capital gains (including up to a $500,000 homeowner exemption), helped to ignite the real estate boom in the first place.

While some contend that the boom in residential real estate has pushed real home prices to record -- and unsustainable -- levels, this depends on the definition of real. If we use gold (which is real) as a deflator instead of the Consumer Price Index (which is not), the median home price stood at $216,200 as of October 2005, compared with $334,000 (in 2005 gold-based dollars) in July 1970. In other words, while there might be froth around the edges, median home prices have yet to fully catch up with the decline in the value of the dollar since the U.S. left the last vestiges of the gold standard more than three decades ago.

Unfortunately, the ongoing debate over the existence of a house price bubble and its likely aftermath has pushed the news of an economic acceleration out of the headlines. Business equipment production rose 6.5% during October, more than offsetting the 4.6% decline during September, when the effects of two major hurricanes and the Boeing strike slashed output. High-tech production, which hasn't missed a beat, is up 24.8% year-over-year, the fastest annual rate of increase since the tail end of the tech boom.

Backlogs for non-defense capital goods excluding aircraft and parts, a gauge of future capital spending, accelerated to the fastest three-month annualized pace since mid-2004 in the three months ending in October. The same behavior is occurring in measures of core retail sales (sales excluding autos and gasoline). They rose at the fastest three-month annual pace since early 2004 during the same period. These are signs of an acceleration, not symptoms of a slowdown.

The news on the corporate sector is even better. According to Standard & Poor's, S&P 500 operating earnings have compounded at double-digit year-over-year rates for 13 consecutive quarters. After taking a nosedive during the profitless prosperity of the late 1990s and early 2000s, corporate pricing power is back. Unit prices in the non-farm business sector advanced 2.9% year-over-year during the third quarter, the fastest annual increase since 1991. In short, corporations have both profits and pricing power, which means they have the resources to continue to spend. Since non-residential fixed investment makes up nearly two-thirds of gross domestic investment, these trends should work to offset any weakness that arises on the back of a slower residential real estate market.

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Yet despite the favorable disposition of many indicators of grassroots growth, there are real risks to the outlook. If destructive tax hikes emerge from a failure to extend the 2003 tax cuts on capital gains and dividends, asset prices would have to adjust lower to reflect lower expected after-tax returns. At the same time, if the Fed eventually becomes overly restrictive with short rates and liquidity, the household and corporate sectors could weaken in unison.

While the outlook for tax policy is up in the air, it is worth noting that dual weakness in the housing and corporate sectors during previous decades typically followed in the footsteps of the Fed pushing short-term interest rates five percentage points or more above the core inflation rate. This would require a 7% funds rate at today's 2% rate of core inflation -- three full percentage points above today's Fed funds target rate of 4%. With liquidity-sensitive precious-metal prices surging to levels not seen in decades and real short rates still below historical norms, the risk of near-term Fed overshoot is not compelling. Instead, an underestimation of just how strong the economy is, and how easy the Fed has been, is likely to come into further focus during the quarters ahead.

Mr. Darda is chief economist and director of research for MKM Partners.