All told, the U.S. economic expansion appears to be solidly on track. Nevertheless, the outlook for real activity faces a number of significant risks, including the possibility that house prices and construction could retrench sharply and that energy prices could rise significantly further.

The possibility remains that the recent run-up in [housing] prices may be greater than can be justified by the fundamentals and that increases in house prices may moderate or undergo a sharper adjustment. The latest data on house prices--including the figures released this week--provide a hint that a moderation in house prices, and nothing more serious, may now be under way.

It seems to be the case - there are some straws in the wind that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate; that house prices will probably continue to rise but not at the pace that they had been rising.  So we expect the housing market to cool but not to change very sharply.  If the housing market does cool, more or less as expected, that would still be consistent with a strong economy. In 2006 and 2007, in particular, capital investment and other forms of demand would take up the slack left by residential investment.

Certainly, analyses do indicate that house prices are abnormally high—that there is a "bubble" element, even accounting for factors that would support high house prices, such as low mortgage interest rates. So a reversal is certainly a possibility.

Transactions in second homes, of course, are not restrained to the same degree as sales of primary residences--an individual can sell without having to move. This suggests that speculative activity may have had a greater role in generating the recent price increases than it customarily has had in the past.

While I'm certainly not predicting anything about future house price movements, I think it's obvious that the housing sector represents a risk to the outlook.

Most economists expect housing prices to begin to stabilize as long-term interest rates adjust upward. As this occurs, the speculation present in some markets will eventually dissipate and price increases should slow.

The housing boom will inevitably simmer down...As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures.

If a sizable reversal in house prices were to occur, it probably would affect the economy mainly through the lagged effects of declines in wealth and increases in interest rates, rather than through widespread financial disruptions. This would give monetary policy time to react to any resulting economic weakness by lowering interest rates. In addition, the magnitude of the potential house price overvaluation may be only around half that of the earlier stock market overvaluation.

Housing prices, like other asset prices, are a relative price, and I don't see those as a direct driver of inflationary trends.

CNBC INTERVIEWER: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying ‘Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.’ Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.

It seems quite reasonable to foresee at some point house price appreciation leveling off and investment in housing tapering off to some extent.

Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications.

Right now, housing prices in many markets in the United States are relatively high when judged by conventional valuation measures. To know if housing is fairly valued requires assessing whether today's valuations are consistent with unobservable future rents, interest rates, and returns--concepts for which we have only rough proxies. However, in some markets the most prudent judgment is that the growth of house prices will slow from the rapid pace experienced most recently.

A second observation concerns the housing market, which you have already discussed. A couple of years ago I was fairly confident that the rise in real estate prices primarily reflected low interest rates, good growth in disposable income, and favorable demographics. Prices have gone up far enough since then relative to interest rates, rents, and incomes to raise questions; recent reports from professionals in the housing market suggest an increasing volume of transactions by investors, who (along with homeowners more generally) may be expecting the recent trend of price increases to continue. Even so, such a distortion would most likely unwind through a slow erosion of real house prices, rather than a sudden crash.