Jan Hatzius, an economist at Goldman Sachs & Co., just wrote an interesting report that should make anyone who bought at the top in a bubble market feel a little queasy. By his calculations, Hatzius believes that given the sharp rise in housing prices, coupled with the rise in mortgage rates, that home prices are about 20% overvalued at present. Hatzius isn’t predicting an outright plunge in prices. He believes the bubble could be unwound either through a stretch of time where prices stay stagnant until incomes catch up (which is what he calls, in econo-speak, his “baseline assumption”), or a significant drop in interest rates. Or through an outright decline in home prices.

Of course, all markets aren’t created equal. Hatzius believes the biggest overvaluations are in overheated markets like California, which he believes are overvalued by 30% to 40% based on the historical relationship between housing prices, interest rates and incomes. (Going city by city, he thinks Boston is 27% overvalued, Chicago 20%, Las Vegas 34% overvalued, LA and Miami are both...

...LA and Miami are both 40% overvalued. New York is 29% overvalued and in Washington DC , prices are roughly 32% too high, he estimates.)

In Texas, Atlanta and Cleveland, he finds no meaningful overvaluation, though he notes that’s partly because in cities like Atlanta and Dallas, the abundance of space has allowed developers to just throw up new houses left and right – creating supply that, if demand cools sharply enough, could create a supply-demand imbalance in itself.

Hatzius believes this has implications for Fed policy. Given the deterioration in housing affordability, he believes the Federal Reserve will end its tightening campaign at 5%. He believes that the deterioration in housing will become more pronounced in coming months, which will give the Fed pause.

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