House values do rise periodically, but normally rents go up with sale prices. This time is different. In places such as San Francisco, where sale prices have risen fastest, it is now cheaper to rent than to buy. As a result, the ratio of the market value of the housing stock to its rental price for the country as a whole - the equivalent of a price-earnings ratio for housing - is now 33 per cent above its historical norm.
Eventually, the housing/rent ratio has to return to normal. Either housing prices will fall, or rents will rise. Regardless of which it is, the movements will have to be large. If market prices are the source of the entire adjustment, the value of residential real estate will have to decline by 25 per cent, or $6,000bn. Since consumption changes by 1.5 per cent for each 10 per cent change in housing wealth, this would imply a $325bn decline in consumption. That means a 2.6 per cent fall in gross domestic product. Even if this is spread over several years, as seems likely, it is still enormous.
The alternative is that the housing/rent ratio reverts to normal through a 33 per cent rise in rents. This is inflation, pure and simple. Since nearly one-third of the American Consumer Price Index is based on rents, this would have big inflationary implications. If the adjustment were to occur smoothly over five years, the result would be an additional one percentage point a year.
As one of the Cassandras in the crowd, I am required to mention the implication of the fact that US national saving is going to have to recover eventually. Today, American households save nothing. In fact, in the aggregate they borrow 1.5 per cent of their income. That is an additional $132bn per year of debt added to household balance sheets. Households will have to stop borrowing and start saving. When they do, consumption will have to fall.
So, the consequence of the five-year-long housing market binge will be a hangover with a combination of collapsing consumption and rising inflation. This puts policymakers in a bad spot, since a drop in real growth calls for a policy easing, while an increase in inflation requires tightening.
If we were not all in this together, I might find it hard to feel sorry for the members of the Federal Open Market Committee, who are going to have to figure this out. Did they not create the problem by keeping interest rates, and hence mortgage financing rates, so low for so long? The US has had four years of accommodative policy, three with the federal funds rate below the inflation rate. Was this really necessary?
On the surface it looks like low interest rates were an essential strategy required to avoid an even bigger mess. After all, inflation in 2003 did fall dangerously close to zero. Or did it? The official numbers are based on the rents that were depressed by the housing boom. Replacing the rental prices with home purchases prices, which means assuming that the ratio of the market value of the housing stock to its rental price is roughly constant, gives a completely different picture. The change raises average inflation by roughly 1.3 percentage points from 2000 to 2005.
Instead of worrying about inflation falling below zero, in 2003 Fed policymakers would have been worrying about inflation rising above 3 per cent. Instead of talking about the dangers of deflation, Fed officials would have been discussing the need to fight inflation and keep it closer to 2 per cent.
Learning from this experience suggests that we modify the way in which inflation is computed, using the changes in the sale prices of existing homes to measure the increase in the price of putting a roof over our heads. This should be included in the CPI. Today, this modified index is running at about 4 per cent. Inflation is not just a risk on the horizon, it is here.
The statement following last week's FOMC meeting shows that policymakers' realise the problem and intend to keep raising interest rates. That means Ben Bernanke, the incoming chairman, begins his term with continued interest rate increases. We all hope that house prices do not collapse, consumption growth remains strong and that policymakers get the balance right.
Stephen G. Cecchetti is Professor of International Economics and Finance, Brandeis University, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.