Shrinking inventory and a shift toward short sales is causing analysts at Bank of America Merrill Lynch (BAC) to dramatically revise their predictions of how high home prices will travel this year and next.

After saying earlier in the year that national home prices in 2012 will rise just 0.5%, analysts at the bank now feel they will go as high as 2% this year. They also beefed up their 2013 forecast from .3% to 2%.

Most Americans interviewed by Fannie Mae believe home prices will increase at least 1.4% over the next 12 months, the government-sponsored enterprise said.

The trajectory for the next several years changed little, however. The bank forecasts cumulative appreciation of 44% over the next ten years.

The revisions for 2012 and 2013 are a result of two national trends: inventory declining by more than analysts expected and a shift toward short sales as a means of liquidating delinquent loans.

The slower flow of distressed homes to the market and less non-distressed inventory is resulting in the depressed inventory. And housing turnover has fallen to a historic low, particularly for turnovers not due to foreclosure. A reduction in turnover not only translates to less supply, it also curbs demand.

“There are a few interrelated reasons for the exceptionally low rate of turnover. Most important is the health of the economy,” BofA analysts said. “With low-income growth and high unemployment, there are fewer “move-up” buyers and slower household formation.”

A shift toward more favorable disposition strategies is also occurring, with the number of short sales increasing over the past several months. Short sales typically sell at roughly a 15% discount to non-distressed properties while REO sales sell at roughly a 40% discount. The larger discounts for REO sales can be due to factors such as neglect of basic home maintenance as the home goes through the more extensive foreclosure process.

“Recognizing the better execution through a short sale, mortgage servicers are increasingly employing the short sale strategy to dispose of homes when the borrower goes delinquent,” BofA said. “Because of this, we anticipate that the share of short sales over REO will continue to grow.”

RealtyTrac vice president Daren Blomquist told HousingWire the financial incentive for lenders somewhat favors the short sale disposition model since the average short sale brings in about $175,000. That is much higher than the average REO resale, with average sales hovering in the $147,000 range.

Analysts still expect home price to soften around the turn of the year with quarterly declines in the fourth quarter and first quarter of 2013. “That said, prices should remain positive on a year-over- basis,” they said. “The recovery has begun, but we caution that it will be gradual and bumpy at the start.”

The weakening forecasts in the next two quarters is a reflection of analysts’ expectations that gross domestic product growth will slip to 1% in the fourth quarter. The slowdown owes to an uncertainty shock brought on by the fiscal cliff.

“When faced with an uncertain economic and regulatory environment, corporations will likely slow investment in equipment and software and consumers will cut back spending on big-ticket items such as autos and homes,” BofA said. “We therefore expect home sales to slow at the end of the year, which will push up months supply.”

And adding to higher months supply is the acceleration in the foreclosure process, which will result in a modest pickup in the flow of distressed properties. Analysts suspect the seasonal factors for the Case-Shiller index have were too large this past winter, biasing prices higher. They therefore risk being too low next winter and hence bias prices lower.