A decade after the U.S. housing market collapsed, FederalReserve officials are watching rising apartment towers as the nextpotential asset-price bubble, which could add to the debate aboutthe pace of interest-rate hikes this year.

Fed Chair Janet Yellen cited commercial real estate prices as“high” in a speech at Stanford University on Jan. 19. That messagehas been echoed by Governor Jerome Powell, who warned “low ratesmay lead to a reach for yield,” as well as Boston Fed PresidentEric Rosengren, who cited luxury housing in his city.

While single-family housing prices have had a gradual recoveryfrom the mortgage bust, commercial real estate is showing signs ofbeing overheated in markets such as New York, San Francisco andBoston. Fed officials have mostly said they plan to addresspotential asset price bubbles with financial supervision, ratherthan by raising interest rates at a faster pace than they currentlyexpect. But such hot-spots are testing their patience.

“It's an important sector and so has to be on the radar screen,”said Jonathan Wright, an economics professor at Johns HopkinsUniversity in Baltimore and a former Fed economist. “At least acouple of bank presidents would see it as a substantive argumentfor tighter policy. But I don't see any indication that the centerof the committee is inclined to adopt a faster pace oftightening.”

On Wednesday, the Federal Open Market Committee reiterated plansto raise rates gradually, and no one dissented from a decision toleave the federal funds rate target range at 0.5% to 0.75%.Officials have penciled in three quarter-point rate hikes thisyear, according to the median quarterly estimate submitted byofficials in December. Investors see the central bank taking itstime, with a roughly 70% probability of a quarter-point hike by theJune FOMC meeting.

The Fed targets maximum employment and 2% inflation, but is alsoconcerned about ensuring financial stability and not repeating themistakes of the last crisis, which originated in an overheatedresidential property market.

“I would describe financial stability risks at this point asbeing moderate — so not elevated, not zero, but moderate,” Yellensaid Jan. 19.

The Moody's/RCA Commercial Property Prices Indices, which coverapartment, retail, office and industrial sectors, dropped 40% fromthe start of the last recession in 2007 to the end of 2009. They'vesince more than doubled and now stand 23% above the pre-crisispeak.

The Fed's Beige Book of anecdotal reports, while noting healthymarkets mostly, cited some worries including that New York City'srental market has “weakened noticeably” and “rents of larger unitshave declined.”

“I continue to be concerned about the commercial real estatemarket,” Rosengren said in response to questions on Jan. 9 inHartford, Conn. “If you look at prices of commercial real estate,particularly multifamily properties, they have been going up veryrapidly in many parts of the country.”

All around Boston luxury apartment or condos have sprung up, hesaid. “They are all very expensive properties,” he said. “It variesdepending where you are in the country, but I think it is certainlysomething we should be watching.”

The Fed's concern has been building for a while. In September,Yellen pointed to Rosengren as a point person monitoring of themarket.

“Of course, we are worried that bubbles could form in theeconomy,” she said at a press conference. While it's difficult todetermine a bubble in real time, “We are monitoring these measuresof valuation and commercial real estate valuations are high.”

In December 2015, the Fed along with two other bank regulators,the Federal Deposit Insurance Corp. and Office of the Comptrollerof the Currency, warned banks to be “prudent” in managing risks incommercial real estate lending.

That caution has done little to stop the momentum in the market,and an adjustment could be in store in 2017.

The delinquency rate for commercial mortgages that have beenpackaged into bonds is forecast to climb by as much as 2.4percentage points to 5.75% in 2017, reversing several years ofdeclines, as property owners struggle with maturing loans,according to Fitch Ratings.

Exactly how the Fed would deal with that is a question mark.

Banks with high levels of lending concentrated in commercialreal estate face “increased regulatory and investor scrutiny,” bankanalyst Laurie Hunsicker of Compass Point Research & Tradingsaid in a Jan. 12 report. That is likely to slow their lendinggrowth in the sector and be a drag on earnings, she said.

For all the stepped-up concern, bank supervision is in a periodof transition. U.S. President Donald Trump can appoint a Fed vicechairman for supervision, a role currently performed by GovernorDaniel Tarullo, who has led the Fed's push for stricterstandards.

Yellen and other officials say supervision should be the firstline of defense for preventing bubbles, while leaving open thepossibility of using monetary policy, because it gets into all thecracks in financial markets that may be missed by regulation.

“CRE prices have objectively gone up, and even anecdotal reportssuggest some froth in that market,” said Roberto Perli, a partnerat Cornerstone Macro LLC in Washington and a former senior Fedeconomist. Yet the repeated warnings may not have much of a policysignal. “Most people at the Fed still think the funds rate is notthe appropriate tool to address potential financial instabilityissues,” he said.

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