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Home Price Indexes

According to most major measures, home prices are declining - and if market commentators are right, prices may continue to fall in the near future. This decline may be hard to stomach for recent home buyers, home sellers, or those in need of refinancing, but should it really have been so unexpected?

Real Home Price Indexes

Over the past 30 years, and presumably even before that (we don't have much data prior to the mid-1970s) nominal home prices have risen steadily. According to the data we do have, prices have risen approximately 2-2.5 percent annually on average after adjusting for inflation. Of course, price growth isn't within this range every year, but prices do seem to dance around it. Growth of this sort is often referred to as mean reverting since the series fluctuates in the short term but always seems to return to the average rate of growth in the long term. If home price growth is in fact mean reverting, one would expect periods of above-average growth to be followed by periods of slow growth - barring any fundamental shift in the market. For instance, one of the many factors that influences the price of homes is population growth; if population growth were to fall permanently from its long-term average of 1.3 percent to, say, 0.8 percent (the long-range growth forecast of the Census Bureau), we would expect the average growth rate of home prices to permanently shift down as well.

In reality, it is difficult to tell whether changes in price appreciation are the result of fundamental changes in the market or just short-term changes due to speculation or varying economic conditions. If we assume for the sake of argument that there hasn't been a fundamental shift in the market, we should be able to get a good idea of how much farther home prices might fall by looking at the price levels warranted by their average long-term growth rate.

To calculate this estimate of where home prices "should" be, we need to make a few additional assumptions. The first assumption is that home prices grow at a constant rate over time. The second assumption is that all of the available data are valid and consistent with the first assumption. This means we won't exclude periods where the growth might seem atypical. Using a basic loglinear regression, we get the following two pictures of our estimates.

Case-Shiller Real Home Price Index
Case-Shiller Real Home Price Index

According to these rough estimates, homes prices are still above the levels warranted by their average growth rates and therefore seem likely to fall somewhat in the future. Just how much they are likely to fall depends on the index one looks at and how much one expects the market to compensate for the above-average growth of the past few years. As the charts show, housing prices seem to be mean-reverting: Periods in which prices are above their "expected" levels are generally followed by periods in which prices are below these levels. Keep in mind that these are real figures and that any future inflation reduces the amount by which home prices are likely to fall.

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