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.  

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.

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.

The increase in the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages are developments of particular concern...Some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market.  Moreover, these contracts may leave some mortgagors vulnerable to adverse events.

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.

The recent Interagency Credit Risk Management Guidance for Home Equity Lending was not a regulatory effort to combat a housing price bubble, nor was it an example of regulatory suasion aimed at asset prices.  Rather, it was a response to indications that some banks were not appropriately managing risks in the home equity area.  The regulatory system is not designed to influence or control asset bubbles, but rather to ensure that bubbles, should they develop, do not lead to unsafe lending practices.  Although the guidance was not aimed at affecting asset prices directly, it may nevertheless affect market conditions through changes in the availability of credit for some riskier households.

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.

I don't see a bubble in the sense that property values over the United States as a whole are at a level that could radically drop in value...there are local markets where it is hard to really believe the underlying demand for housing can sustain the current prices...It's very localized...We're seeing faster property prices going up in leisure locations on the coast and in Las Vegas.

Although a "bubble" in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.

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.

Is [housing] a bubble?  Nobody ever knows for sure until one pops.  I wouldn't rule out the possibility that there's a bubble and we could have house price declines ahead.  If you look at the past history of housing prices, it's rare to see very rapid declines in house prices...I wouldn't expect house prices to increase as rapidly as they have in the last couple years.  I would expect a more normal period of moderate house price appreciation.

A number of analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode. Their concern is that, if this were to occur, highly leveraged homeowners would be forced to sharply curtail their spending. To be sure, indexes of house prices based on repeat sales of existing homes have significantly outstripped increases in rents, suggesting at least the possibility of price misalignment in some housing markets. But a destabilizing contraction in nationwide house prices does not seem the most probable outcome...House prices, however, like those of many other assets, are difficult to predict, and movements in those prices can be of macroeconomic significance.

One caveat for the future is that the recent rapid escalation in house prices--11 percent in 2004, according to the repeat-transactions index constructed by the Office of Federal Housing Enterprise Oversight--is unlikely to continue. A plausible scenario is that house prices will either move sideways or rise more slowly during the next few years, eventually bringing the rate of return on housing in line with the relatively low prospective rates of return that we currently observe on virtually all assets, both real and financial. If the increases in house prices begin to moderate as expected, the resulting slowdown in household wealth accumulation should lead ultimately to somewhat slower growth in consumer spending.

I think it's reasonable to forecast a steady decline in residential investment, no collapse, but a steady decline.