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It's all about real home prices

Until the decline in home prices is halted, the battered housing market won't be able to recover nor will the economy be able to return to sustainable trend-like growth.

And home prices won't recover until housing becomes more affordable -- and that will require a prolonged decline in mortgage rates.

That's the conclusion that Lakshman Achuthan, managing director at the Economic Cycle Research Institute in New York, draws from the recent behavior of ECRI's U.S. Leading Home Price Index.

"We expect this price trend to continue on a downward swing," he said. "This will continue until the Federal Open Market Committee can drive mortgage rates lower and boost housing affordability."

The Key Role Of Home Prices

Home prices are currently playing two important economic indicator roles:

-They reflect the health of the residential real estate sector itself. Rising real home prices signal a healthy, thriving real estate market.

-An increase in home prices bolsters household wealth since home equity represents the largest portion of household wealth. It still accounted for more than 36% of net worth at the end of June, down from 37% in March. An uptrend in home prices is desirable as it increases the wealth effect and consumers' ability to maintain spending -- a key element of economic growth.

But nominal home prices have been on an accelerating downtrend in recent months.

Nominal existing median home prices were down 2.4% for the month in August and down 0.3% from a year earlier, and new median home prices were down 8.4% month-to-month, and 7.5% year-to-year.

September data are due Wednesday and Thursday respectively.

ECRI combines new and existing home prices (there are roughly seven times as many existing home sales as new home sales) and deflates the result to get a composite measure of real median home prices.

The August reading for that composite measure hit a three-year low and the September reading of ECRI's U.S. leading home price index pointed to continued declines.

Moreover, the declines in real home prices occurred in all four regions of the country -- Northeast, Midwest, South and West.

An upturn in real median home prices is seen as a precondition for a resumption of a sustained overall growth rate. That is still a development that is a hope, not yet a reality.

Higher home prices will reflect stronger demand for housing which would signal a turnaround in one of the weakest sectors of the economy.

In addition, it would accompany a further increase in household wealth that would supplement income gains and fuel consumer spending.

The Fed's Role In Housing

The Federal Reserve has no direct control over mortgage rates, which, in the case of fixed rates, are tied to the 10-year Treasury note's yield.

Indeed, in the past years, the Fed has been stymied by the behavior of long-term rates, which remained low even as the central bank embarked on a campaign to raise short-term rates. Now, however, long-term yields have risen back above short-term yields as the market prices in rate cut expectations and concerns about inflation push yields higher on longer-dated maturities.

What the Fed can do, in Achuthan's view, is use the communication of its policy intentions to investors as a way to influence the direction of long-term rates.

He points to the statement following the Sept. 18 policy meeting -- at which the Fed cut the federal funds and the discount rate each by 50 basis points to 4.75% and 5.25% respectively.

That statement said that "economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally."

If the Fed keeps the housing market front and center in its assessment and continues to play down its inflation concerns, Achuthan believes that financial market participants may feel more comfortable with lower long-term rates -- including mortgage rates.

Moreover, Achuthan points out that the Fed should be able to lessen its inflation concern given that ECRI's future inflation gauge is showing that "underlying inflation pressures remain in a cyclical downtrend."

The FOMC next meets for a two-day meeting that ends Oct. 31. Markets are expecting a 25 basis point rate cut and another cut in the discount rate -- which, if that rate is brought in line with the funds rate, could help push lower the London interbank offered rate that forms the base for adjustable rate mortgages.

Fed officials have played an even hand as the next meeting approaches, acknowledging the decline in price pressures excluding the volatile food and energy sectors, and the dire state of housing, while at the same time affirming the Fed's focus on inflation.

Chairman Ben Bernanke, speaking in New York last week, noted the central bank stands ready to act if the downdraft in housing and related credit market turmoil hurt the economy. But he also stressed that the Fed is ready to reverse September's rate cuts if inflation gets out of control.

(John McAuley, a special writer who covers the economy for Dow Jones Newswires, is a former Wall Street economist. He holds a Ph.D. in international trade and macroeconomics and has taught economics at Fordham University since 1974.)