The real estate bubble will take longer to burst

There is an entire ecosystem, from real estate companies to banks, that likes the idea of a real estate bubble continuing, Photo: Mint 
There is an entire ecosystem, from real estate companies to banks, that likes the idea of a real estate bubble continuing, Photo: Mint 


Super-cheap credit pumps up home prices but central banks are wary of taking deflationary action

Last Friday, Jerome Powell, chairman of the US Federal Reserve, re- iterated in a short speech the importance that the Fed was placing on bringing down inflation to 2%. In order to control inflation, the Fed will keep trying to push up interest rates. With rates going up, people and firms will consume and spend less money than in the past. This will control demand and help contain inflation.

It will also lead to higher equal monthly instalments on home loans. In fact, that has already been happening, but despite that, home prices remain strong. There has been a bubble in home prices in the US since the beginning of 2021. As per the S&P-Case Shiller US National Home Price Index, real estate prices have been rising at 18-20% per year since June 2021 and until May, the latest data point available. Such a nationwide price increase wasn’t seen even in the period 2004 to early 2006, when a huge real-estate bubble built up in the US. The highest annual increase in home prices during that cycle stood at around 14.5% in September 2005.

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As of June end, the latest data available, the median sales price of houses sold in the US stood at $440,300, or around 15% higher than the same period last year. Some private datasets suggest that home prices have fallen post-June, but the yearly return continues to stay in positive territory.

The irony here is that the Fed had a huge role to play in creating the US real estate bubble. It is widely believed that a central bank can only influence short-term interest rates. When it comes to long-term interest rates, these are determined by other factors—everything from the supply of savings to economic productivity and the demand for loans.

While this might have been true in the pre-2008 world, since then rich-world central banks have been printing money and pumping it into the financial system, pushing down long-term rates.

Further, since late 2019 and the start of 2020, rich-world central banks are said to have printed close to $10 trillion in different currencies. In the very-low-interest rate environment that followed, money in search of higher returns found its way into everything from stocks to real estate to cryptocurrencies.

While the stock market and crypto bubbles across the rich world have burst, the real estate bubble will take time to, given that central banks took their own sweet time to act.

In the period of three months ending last September, the median home price in the US had risen by 22% on an annual basis. The Fed first talked about raising long-term interest rates, by taking out the money it has printed and pumped into the financial system, only in May.

Further, there is always a certain reluctance among central bankers to prick a real estate bubble. Alan Greenspan, who was chairman of the US Fed from 1988 to 2006, believed that it was best to ignore bubbles because it was impossible to identify them in real-time. Instead he believed in mitigating the fallout of a burst. The question is: If a central bank cannot identify an asset bubble when it is alive and inflating, how could it possibly know that it has burst.

Even in cases where a central bank doesn’t believe in this, it is difficult for it to raise interest rates to deflate a bubble, given that the primary mandate of most central banks is to control retail inflation.

In fact, something like this played out in Japan in the mid to late 1980s, when the country saw the inflation of a huge real estate bubble. As Edward Chancellor writes in The Price of Time: “Officials at the Bank of Japan… admitted that the absence of [consumer price] inflation at the time had made it difficult for them to respond to the bubble in a timely fashion." Over and above this, there is a fear of pricking a bubble and thus engineering an economic recession.

Also, there is an entire ecosystem, from real estate companies to banks, that likes the idea of a real estate bubble continuing. This is reflected in their communication in the media, leading many investors, home-owners and prospective home-owners to believe that the good times are likely to continue.

In the short-term, if investors believe that the good times are likely to continue, they do continue, at least for slightly longer. In the long-term, the ecosystem feeds into stories like how owning a house is a very important part of the American dream.

To conclude, before the sub-prime crisis, the annual increase in home prices in the US peaked in September 2005. It took 17 months for annual returns to turn negative. Once that happened, the annual returns were negative for the next 62 months. Something similar happened when the Japanese real estate burst in 1990 and continued to deflate for a while. As Chancellor writes: “Credit booms and real estate bubbles often produce nasty economic shocks and are followed by weak recoveries."

Finally, high real estate prices push up home rents. This data forms a significant portion of the indices used to calculate general inflation. Hence, the way to control inflation is to contain the pace of increase of home rents. And the way to do that is to try placing a lid on rising home prices. And the way to do that, in turn, is to increase interest rates. The Fed will continue to do that in the near future, until it has deflated the US real estate bubble. But that will take time.

Vivek Kaul is the author of ‘Bad Money’.

Elsewhere in Mint

In Opinion, C. Rangarajan writes on policy cues from a depreciating rupee. Diva Jain reveals how special interests push the ESG bandwagon. Vivek Kaul explains why real estate bubbles are easy to inflate but difficult to prick. Long Story tells how dark stores have become the bright spots in real estate.

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