Rational Exuberance

Robert Pillote
5 min readApr 26, 2022


Homes are expensive, but there’s not a bubble

Last month the Dallas Fed made waves when it published a report titled “Real-Time Market Monitoring Finds Signs of Brewing U.S. Housing Bubble” (emphasis mine). It is newsworthy, and perhaps even a little alarming, that a federal agency populated by professional economists was willing to use the term “bubble” so bluntly. And while their report has scholarly merit (you can read it here) I think it ignores a more powerful factor driving trends behind the scenes: houses are growing more expensive because they are increasingly scarce.

The Dallas Fed report does not mention housing supply. The authors instead focus on macroeconomic indicators and attempt to quantify housing market “exuberance,” which they define as home price appreciation beyond what would be expected from market fundamentals. Their measure for exuberance shows a long build-up to 2006 followed by a dramatic crash, strongly suggesting exuberance is a useful signal and not just noise.The report notes exuberance is once again spiking:

The authors conclude: “Our evidence points to abnormal U.S. housing market behavior for the first time since the boom of the early 2000s.” I do not disagree with this point — housing market behavior very clearly is abnormal, and the data undeniably show the relationship between home prices and imputed rents¹ is diverging from historical norms. But I do not believe the current inflation is a bubble because bubbles, by definition, eventually pop; and I do not see economic headwinds that could change the course of this housing market any time soon.

For comparison, let’s revisit the 2006–09 crash. The downfall of the market was kicked off in earnest in the second quarter of 2007 when a large wave of adjustable-rate mortgages defaulted. Critically, this was a foreseeable event, and hedge fund manager Michael Burry (of The Big Short fame) saw it and very successfully bet against it. Any other investor could have looked at the same data Burry did and reached the same conclusion (it was the extent of the contagion to the rest of the financial economy and subsequent liquidity crisis in September 2008 that came as a real surprise).

So is there another ticking time bomb of adjustable-rate mortgages waiting to blow up? No. Just 10% of mortgages are ARMs, and borrowers are far more creditworthy than they were during the last cycle. The federal government also demonstrated a willingness to deploy extraordinary assistance to homeowners during the first phase of the pandemic, and that combined with the personal income gains due to fiscal stimulus and a strong economy mean homeowners are in a better position than at any point during the last 20 years. (If there is a ticking debt bomb in the economy, it’s probably auto loans.)

Homeowners are also unlikely to move from and/or rent out their residences, as lagging imputed rents might suggest,² for no other reason than there is nowhere else to go. Home vacancy in 2021 was a scant 0.9%, the lowest value ever reported by the Census Bureau and well below any value recorded during the last exuberance window identified by the Dallas Fed (1998–2007). Rental vacancy hit 5.6% in Q4 2021, the lowest value since 1984 and, again, well below anything observed during the ‘aughts. Nominal housing starts have caught up to where they were in 2002, but on a per-capita basis the US has been building fewer homes than at almost any point since 1959 — for the past 12 years.

That’s the root of inflation in the housing market: The US has persistently underbuilt homes for over a decade and is now, thanks to a large demand shock, paying the price. The divergence of price from imputed rents is not a bubble but a deviation to a new normal, and investors are piling in — rationally. The Dallas Fed report claims just the opposite, that buyers are caught up in a “fear of missing out” that must be irrational because such short-term price gains cannot be sustained forever. And while I do not see the rate of increase holding up, the supply crisis means the price of housing is unlikely to come down. If you want to buy a house you had better do it now, because it will only be more expensive in the future. Millions of homebuyers have recognized this and acted accordingly.

The distinction between “bubble” and “epic supply crunch” may seem academic, but policy responses to the current state of the housing market will have very real consequences. If there is truly a bubble, then economic policymakers need only temper expectations of future home price appreciation (most likely via the Federal Reserve raising interest rates) and home prices should return to their fundamental level. This is exactly the wrong approach to take if homes are expensive because they are overly scarce. Dampened expectations about future homebuyer demand will lead to builders producing fewer homes, not more, and the US will remain stuck in its underproduction trap. Home prices will stay elevated until more homes are produced.

The Dallas Fed is right to point out that something is up in the US housing market, but labeling it a bubble could have disastrous policy consequences.

[1] “Imputed rent” is the amount a homeowner could expect to earn from renting out their house to somebody else. We call it “imputed” because it is estimated based on a comparison between actual owned and rented properties. When home prices rise faster than imputed rents, that implies buyers are paying more for their homes than they are economically “worth.”

[2] If you are paying $3000/month for your mortgage, but a comparable home across the street is renting for only $2000/month, you would sell your house and move, right? (Maybe not, because humans are not always economically rational, but that’s for a different blog post.)