The Fed meeting and deflation: Why the US need not fear the fall in home prices.

Some new home construction in West Sacramento in July. Sales of new houses across the Sacramento area fell to a new modern low in the second quarter of 2010

Fear of deflation was likely the main topic at today’s meeting of the Federal Reserve’s Open Market Committee. Deflation is an unusual and rare phenomenon, one that can spook markets, as it creates a decline in the willingness of consumers to buy goods because they think prices will continue to fall.

This downward spiral is hard to break, as Japan knows all too well after its housing and stock-market bubbles burst nearly two decades ago. So all eyes have been on the Fed to prevent deflation in the US by further stimulating the economy through monetary means.

So far, however, fear of deflation seems unfounded as the consumer price index remains positive – barely. But it really seems odd because the United States is already experiencing deflation in one industry that makes up nearly a quarter of the economy – housing. And that widespread drop in home prices is a necessary correction after the incredible bubble in housing from 2004-2007.

Rather than let home prices drop back to pre-bubble levels – say, like to the prices of the early 1990s – the government has instead tried to prop up demand. It rescued Fannie Mae and Freddie Mac, bought up mortgage securities, and offered a hefty tax credit for first-time home buyers.

But home prices will likely continue to fall, despite a recent uptick caused by the tax credit, which expired in April. The median price of a new single-family home was $213,400 in June, down from a peak of $247,000 three years ago.

At some point, potential home buyers will get off the sidelines and start buying homes – as merely a nice place to live in, not necessarily as an investment.

A poll by MacroMarkets of more than 100 economists indicates that the average home price will drop by some 2 percent over the next year. Some cities may see sharper declines. The Fiserv Case-Shiller Indexes forecast a decline of 4.9 percent.

Not only will this lowering of prices help buyers, but this correction will send a strong signal that the nation’s excess wealth would be better invested in industries that create competitive exports in world markets.

Deflation in one sector, housing, may be a good thing. But that’s not the case if prices decline broadly for more than a few months. It is much harder to stop deflation than inflation.

The Fed needs to be cautious in reacting too strongly to signs of general deflation. And it should also not commit the same mistake it did in 2003 and overstimulate the economy because of a fear of deflation. That stimulation was a major force behind the very housing bubble whose collapse is still being cleaned up.

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