U.S. HOME PRICES MAY FALL BUT DROPS WILL BE MILD

U.S. housing prices may decline "a little" within the next year, but any such drop is likely to be mild and inconsistent with a bursting housing bubble, according to a paper written by a Federal Reserve economist.

Based on an analysis of housing futures and options and derivatives of housing-related company shares, "market participants expect home prices to decelerate sharply or actually decline a little within the next year," wrote J. Benson Durham, an economist with the Fed's monetary affairs division. However, the anticipated drop in prices "is mild compared to some estimates of the purported overvaluation of the housing market," he added. The paper, dated September, was posted on the Fed's Web site Thursday.

Mr. Durham cautioned that deep and liquid markets needed to signal future home-price trends don't fully exist and that housing futures and options have only been trading on the Chicago Mercantile Exchange since May 22. Still, implied volatility on CME housing options are greater than the historical average, "which suggests that investors see more risks to home prices going forward," he wrote. That higher uncertainty, however, is "generally inconsistent with the perception of a "bubble,'" he added.

Mr. Durham also examined options on shares of certain homebuilders to gauge whether investors see upside or downside risks to home prices. Those options "are only marginally negatively skewed at the present time," he wrote. "This suggests that market participants do not, in fact, view the risks to home prices or, perhaps more accurately, to the broader housing sector as especially tilted to the downside," Mr. Durham concluded.

The paper's conclusions seem in line with the thinking of Fed officials that the sector will slow substantially through the rest of 2006 and into 2007 but is unlikely to derail the economic expansion.

In the minutes of the Sept. 20 Federal Open Market Committee meeting, the Fed said housing "seemed to be cooling considerably" but that the overall economy should strengthen next year "as the housing correction abated." Officials also continue to remark that higher inflation poses a greater risk than a slower economy.

Housing data had declined markedly in recent months, raising fears of a housing-induced slowdown severe enough that it would eventually require Fed rate cuts. But there have been tentative signs of stabilization of late. The National Association of Home Builders index rose in October, albeit by only one point, but nevertheless breaking a string of eight straight declines. And housing starts unexpectedly rose in September, breaking a string of three straight declines.

-- October 23, 2006

By Brian Blackstone

The Wall Street Journal Online