Many news reports and anecdotes suggest that the housing market is cooling and that investors are participating less actively. However, the construction of new homes has remained near recent highs.

On the demand side, there is some uncertainty regarding the rate at which housing activity is at all likely to cool in the coming year. Although I do not think that a sharp fall in housing investment is likely, a range of forecasts from flat to moderately declining seem reasonable.

The multiple first-day bids and final sales at above asking prices that were observed in some markets seem to have become less common. And in some markets the amount of time a home stays on the market has returned to more typical levels. At the same time, the aggregate measures of housing activity have so far shown only limited pull-back from their peaks and remain at historically high levels. Still, mortgage rates are likely to stay somewhat above their recent lows in the coming year, so I would expect housing price appreciation to flatten out next year and aggregate residential investment to stop growing or perhaps even decline.

Signs point to another robust performance in the fourth quarter, so growth for the last half of 2005 could well come in noticeably above the potential rate.  This positive performance suggests that the overall economy has been quite resilient in absorbing the impact of the storms [Hurricanes Katrina and Rita].  For 2006, it seems likely that this strength will continue in the first half, as rebuilding kicks in.  Then, in the second half, a couple of factors are likely to cause economic growth to settle into a trend-like pattern.  One of the factors is the winding down of the rebuilding effort.  The other is the lagged effect of monetary policy tightening; in other words tighter financial conditions will have some dampening impact on interest-sensitive sectors, such as consumer durables and housing.

Housing has been an area of strength throughout this business cycle, and we've seen strong increases in home prices...Many analysts warn that housing is overvalued. One way we can judge this is by looking at the price-to-rental ratio for housing...Nationally, the price-to-rental ratio has been rising sharply since the mid-1990s and currently is at its highest level ever. However, the price-to-rental ratio has risen only modestly in Chicago and most Midwestern cities; the largest increases have occurred in cities such as Miami, San Francisco, and Las Vegas. These differences highlight the local nature of housing markets. There is little tendency for housing price declines in a particular region to spill over to a more general drop in prices at the national level...If housing does prove to be overvalued and home prices fall, residential construction would be adversely affected. But history suggests that the impact on overall consumer spending would be more modest. Moreover, the changes in wealth and any related spending adjustments likely would be gradual. 

In the United States, signs of froth have clearly emerged in some local markets where home prices seem to have risen to unsustainable levels. It is still too early to judge whether the froth will become evident on a widening geographic scale, or whether recent indications of some easing of speculative pressures signal the onset of a moderating trend.

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.

The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is adding to the pressures in the marketplace.

It is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices. In addition, the LTVs for recent homebuyers appear to be lower in those states that have experienced the most explosive run-up in house prices and that, conceivably, could be at risk for the largest price reversal.

It has been suggested that borrowers, emboldened by rising house prices, are turning to nontraditional mortgages to qualify for increasingly expensive homes, setting the stage for potential repayment problems in the future. In this regard, the Federal Reserve surveyed banks on the importance of nontraditional mortgage products, such as loans with multiple payment options and interest-only mortgages. About 70 percent of those surveyed reported that such innovative products constituted less than 15 percent of the mortgages on their books. Interestingly, more than half the banks indicated that they were about as likely, or somewhat more likely, to securitize these products than traditional mortgage products. It would appear that whatever new risks may be associated with the increasing use of nontraditional mortgages are being dispersed across financial institutions and investors.

Speculative activity was also a part of the loan-officer survey [conducted by the Federal Reserve]. Over the past 12 months, more than three-fourths of the banks said that less than 10 percent of residential mortgage loans they originated went to the purchase of a second home or investment properties. At the same time, delinquency rates provide little reason for concern...Even so, we should not be overly sanguine about the housing boom and associated trends in home-mortgage lending...We will continue to keep a watchful eye for the potential dangers of stagnant or falling home prices in the future, combined with the potential for increases in mortgage payments relative to income.  

The significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor.

Demographers assure us that aging baby boomers, a positive rate of family formation, and continued immigration into the U.S. are at least partially responsible for the relative rise in residential real estate prices. Economists’ best guess is that the underlying fundamentals indicate that housing markets and housing prices should begin to stabilize as the so-called conundrum fades and mortgage interest rates rise.

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.

These phenomena [the growing current account deficit, dwindling household savings, low level long-term interest rates and the rapid pace of house price increases] could well continue for some time longer, but they are not sustainable indefinitely. At some point, global investors will require higher expected rates of return as their portfolios become increasingly concentrated in dollar assets; house price increases will encounter resistance as they rise relative to income and rents; as housing prices level out, households will recognize that they must increase saving out of income to have adequate resources for retirement; and the Federal Reserve already has been raising short-term interest rates as demand recovers from the shocks of recent years.