How Low Will Home Prices Go?

This is a question I keep asking myself, not as an economist but as a potential homebuyer. As I have discussed previously on this blog, I recently moved to Texas from Michigan and am now looking to buy a home. A few weeks ago my wife and I aided and abetted the housing recession. Yes, we are guilty as charged of withdrawing an offer we had on a home under the assumption that the housing market has not hit bottom (there were some other factors as well). It is almost surreal to think I am a part of a downward deflationary spiral in the housing market where expectations play an important role. Of course, the Texas housing market is not the same as the Michigan housing market--where I had to bring money to the table to sale my home--and so I need to be careful in assessing how far home prices will fall here.

Still, I ask how far will home prices fall? The S&P/Case-Shiller house price index for select metropolitan areas and the OFHEO national house price index just came out for the end of 2007 and both show on-going declines across the nation. Below is a graph of the these two (nominal) series in year-on-year growth rate form through the end of 2007.

While this graph is interesting, it does not really provide any insight into my question of how low will house prices go. If we look at the series in the levels we get the following graph:

This figure shows in nominal terms that the home prices reached a peak in late 2006 (Case-Shiller) or early 2007 (OFHEO). The figure also indicates there is much more correction needed for nominal house prices to return to pre-2003 trend levels. This simple 'eyeball' analysis is consistent with what Calculated Risk has reported about futures data on housing prices:

... futures data is forecasting a price drop of 11% over the next year, and close to 25% over the next 3 years for the 25 largest MSAs.

As a home buyer, though, I am also sensitive to mortgage rates and recently they have been going up (see this picture over at the Big Picture). The Wall Street Journal explains why this is happening despite ongoing policy rat cuts:

There are two reasons mortgage rates haven't responded more to the Fed's rate cuts. One is that long-term Treasury yields, which are the benchmark for most mortgage rates, have risen recently, perhaps because of increased concern about inflation as the prices of oil and other commodities soar. The other is that the spread between mortgage rates and Treasury rates has widened as investors and banks become increasingly reluctant to make home loans.

The only way for long-term rates to fall now is for there to be more bad economic news. That would help with the inflation concerns, but it would not eliminate the mortgage-Treasury spread. If the Nouriel Roubini's of the world are correct, and if the mortgage-Treasury spread does not dramatically change, then lower mortgage rates await me in the near future.

So, patiently I wait for further housing price declines and more bad economic news.

Update

James Hamilton discusses the latest housing price data over at Econbrowser.