Why house prices will keep falling

March 29, 2011, 6:09 PM UTC

Unless Ben Bernanke sets off a big inflation wave, house prices are doomed to keep falling for years.

Tuesday’s release of the monthly Case-Shiller U.S. house price index shows a 3.1% year-over-year decline for January. The index of 20 big U.S. cities fell to 140, just a point and change above its spring 2009 low in the wake of the financial meltdown.

Mind the gap

The “dismal” showing included 11 cities hitting postbubble lows and “no real hope in sight for the near future,” according to S&P’s David Blitzer. Robert Shiller, the Yale professor who started the index along with Karl Case of Wellesley, said this month that  “there’s a substantial risk of home prices falling another 15%, 20% or 25%.”

The latest declines have some wags declaring now the time to buy a house. They see a recovering economy boosting incomes, the collapse of the homebuilding industry trimming oversupply and low interest rates making property more affordable than ever.

But this analysis overlooks a stubborn fact Shiller has spent years documenting: that house prices over time tend to rise more or less in step with inflation. And while inflation fears are certainly rising right now, actual inflation as measured by the government remains quite low.

So while house prices have dropped by a third from their bubbly highs in 2006, that only closed part of the gap (see chart, right) between house prices and inflation that opened up during the bubble years. Assuming the Federal Reserve isn’t able to inflate another housing bubble, house prices have much further to fall.

“Despite the 33% drop in the Case-Shiller home price index from the peak, the cumulative gap since 1987 between baseline inflation and home price inflation is still 25%,” Oppenheimer analyst Chris Kotowski wrote in a note to clients this month. “Thus, we believe home prices will still trend flat to down for a number of years.”

A steep decline along the lines of the 2007-2009 plunge isn’t the only way this gap can close, of course. If the Fed does succeed in engineering mild inflation and house prices “bump along the bottom” for a few years, as Case predicts, house prices and inflation could come back into line without much drama.

Even if the economy remains slack and inflation tame, another steep slide in prices may not be in the cards, with the government propping up the big banks and pouring money into Fannie Mae and Freddie Mac to avoid a repeat of the lending collapse of a few years ago.

But consider that even after the recent plunge the 20-city Case-Shiller composite index is at 140, up 40% from its level in 2000 – a period over which the U.S. private sector has created next to no net new jobs and incomes have been flat.

Just to take houses back to their inflation-adjusted 2000 level, the index would have to fall 8% — or, alternatively, Bernanke would have to somehow get inflation roaring in an economy where 1 in 6 people is underemployed. No matter what the hawks are screaming, that’s not going to happen overnight.

So if you want to buy a house, go right ahead — but don’t do it because you think it’s a great investment. Somewhere we have heard that one before.

Also on Fortune.com:

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