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Eye on the Economy: Housing Will Not Drag Economy Into Recession
 The “advance” GDP report for the second quarter of this year showed a convincing downshift in economic growth, to a below-trend 2.5% pace. That estimate is likely to be revised upward to some degree when the “preliminary” estimate is released on Aug. 30, although the second-quarter performance still will qualify as sub par.
Furthermore, GDP growth is likely to remain below trend in the second half of the year, largely because of absolute declines in the housing production component of the economy.
The slowdown in GDP growth naturally has provoked a slowdown in payroll employment growth and an uptick in the unemployment rate (data through July), and weekly data on unemployment insurance claims point toward rather sluggish job growth in August as well. Residential construction employment actually has been falling in absolute terms since a cyclical peak in February, and further declines are inevitable in the months ahead.
Although growth of economic output and employment has slowed from above-trend rates recorded earlier in the expansion, forward momentum still seems solid and outright declines in GDP or employment are distant prospects. Indeed, the current slowdown process is essential to maintaining solid economic growth with low inflation down the line.
Core Inflation Still Is on the High Side, But Some Improvement Should Be in the Cards
Core price inflation has remained on the high side despite the evolving slowdown in the economy. The core consumer price index (CPI) posted a one-month annualized gain of 2.4% in July, slower than during the four previous months, although the year-over-year gain edged up to 2.7%.
The housing component once again put substantial upward pressure on the core CPI, driven largely by the imputed “owners’ equivalent rent” calculation that added about 0.4% to the core inflation rate. Everything considered, the July reading on core CPI inflation was reassuring to both the Federal Reserve and financial markets.
The evolving slowdowns in growth of GDP and employment should take some strength out of core inflation down the line, particularly as generation of slack in labor markets takes some strength out of unit labor costs. Furthermore, the impact of record-high energy costs on core inflation will wane as long as the energy prices don’t keep ratcheting upward.
NAHB’s forecast shows some deceleration of core inflation later this year and in 2007, consistent with the mid-July projections by members of the Federal Open Market Committee (FOMC) that were contained in the Fed’s mid-July semiannual Monetary Policy Report to the Congress.
The Fed’s Policy Decision on Aug. 8 Looks Quite Prescient, at Least for Now
Fed Chairman Ben Bernanke’s mid-July monetary policy testimony before Congress noted an obvious slowdown in economic growth during the second quarter and suggested that below-trend GDP growth was in prospect for both the second half of this year and in 2007.
Indeed, the central tendency of the economic projections by members of the FOMC painted such a picture. Bernanke’s testimony, and the FOMC’s mid-July economic projections, also projected some slow-down of core inflation from the elevated rates of mid-2006.
The Fed’s decision to hold short-term interest rates steady at the Aug. 8 FOMC meeting was based on the conviction that the economic slowdown still has some distance to run and that core inflation is likely to recede in the process. Economic data released since then are broadly consistent with those themes.
If these patterns continue, as we expect, monetary policy will be held steady for some time into the future ― including the Sept. 20 FOMC meeting.
Long-Term Interest Rates Have Fallen Substantially From Mid-Year Highs
The obvious economic slowdown, the convincing nature of Bernanke’s mid-July testimony, the FOMC’s policy decision and statement on Aug. 8 and the recent good news on core inflation have provoked a stunning rally in the fixed-income markets. As a result, longer-term Treasury yields have fallen substantially from their recent highs at mid-year, and those declines have provoked similar declines in long-term mortgage rates.
The bond market rally has produced another significant inversion of the Treasury yield curve (out to 10 years), and that may not be a sustainable relationship.
NAHB’s forecast currently shows a modest firming up of long-term yields (and a flattening of the yield curve) by later this year, with a modest decline in the entire yield structure by late next year. Stay tuned.
The Housing Downswing Continues Despite a Decent Economic/Financial Picture
The recent slowdowns in economic growth and job formation and the (net) increase in mortgage rates during the past year certainly are negatives for the housing sector, although the economic/financial picture still looks reasonably bright. But we’re also coming off a virtual frenzy in housing markets last year, an episode that involved extraordinarily heavy buying by investors/speculators that drove sales, production and price appreciation into unsustainable territory.
The highs in home sales and price appreciation were hit around mid-2005, and substantial declines have been recorded since then (through July). Housing starts and building permit issuance have come down substantially in the process, particularly in single-family and condo markets. (Rental housing is firming up at this time.)
The biggest declines in market volume have been occurring in areas that were the hottest last year — California, Florida, Arizona, Nevada, Hawaii, Virginia, Maryland and Washington, D.C. — and we’re also seeing sizeable declines in Michigan where fundamental economic conditions are in serious decline.
So far, the metro areas showing year-over-year price erosion are heavily concentrated in the weak Great Lakes area of the Midwest region, not in the formerly overheated markets where sales volume is coming down the most.
The Housing Sector Will Not Drag the Economy Into Recession
The persistent erosion of housing market activity has already converted housing from a powerful engine of economic growth into a significant drag on the U.S. economy. In fact, memories of past housing downswings have prompted some analysts to conclude that housing will be dragging the overall economy into recession by next year.
We continue to view the ongoing housing downswing as an inevitable mid-cycle correction from unsustainable levels of activity in both 2004 and 2005, and we expect the housing downswing to bottom-out by early next year.
Our forecast shows contraction in the housing production component of GDP (residential fixed investment) from the final quarter of 2005 through the first quarter of 2007.
The housing downswing is a major factor in our projection of below-trend growth of GDP and employment through the first half of 2007, and that slowdown helps contain those critical core inflation numbers (aside from the perverse impulse from the imputed “owners’ equivalent rent” component that promises to move upward with market rents). But the housing downswing is part-and-parcel of a mid-cycle sectoral rotation that also includes upswings in other parts of the economy — particularly in nonresidential fixed investment (capital equipment and software as well as structures) and exports.
NAHB Chief Economist David Seiders analyzes the economy from the point of view of the housing market every other week in the free e-newsletter, “Eye on the Economy.” The preceding is a reissue of his Aug. 23 edition. To subcribe to “Eye on the Economy,” click here.
 Want to Know Your State's Starts Forecast for 2007?
Find out in HousingEconomics.com’s State Starts Forecast (sample). The starts forecast includes downloadable Excel tables of total, single-family and multifamily starts by region and state.
To learn more, visit www.housingeconomics.com.
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