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Eye on the Economy: Housing Demand May Be Stabilizing
 Growth of real Gross Domestic Product (GDP) slipped to an annual rate of 2.6% in the second quarter of 2006, according to the “final” estimate released by the Commerce Department on Sept. 28. This definitely was a below-trend pace with sobering implications for the labor market.
The housing production component of the economy — Residential Fixed Investment (RFI) ― was the weakest element of the second-quarter GDP report. Indeed, RFI contracted at an annual rate of 11.1% and subtracted 0.72 of a percentage point from the overall GDP growth rate — a massive swing from the 1.11-point positive contribution delivered a year earlier.
The downswing in housing production is also taking a toll on some forms of consumer spending, including the “furniture and household equipment” component of personal consumption expenditures.
Third-quarter GDP growth will be even weaker than the second-quarter performance (we’re currently estimating 2.0%), largely reflecting a further downswing in RFI and associated impacts on consumer spending.
However, we’re projecting somewhat better GDP growth in the final quarter of this year and in 2007 as the housing downswing becomes less severe and other sectors of the economy gain more strength.
Core Inflation Still Looks Troublesome, Despite the Economic Slowdown
The evolving slowdown in growth of economic output (real GDP) and payroll employment is bound to relieve upward pressures on unit labor costs and core inflation, and the recent retreat of energy costs inevitably will limit the “leakage” of these costs into the core inflation numbers. Having said that, there definitely are time lags in those relationships and key measures of core inflation still were elevated in August.
The core Consumer Price Index (CPI) posted an annualized advance of 2.9% in August and a year-over-year gain of 2.8% — well above the upper end of the Federal Reserve’s implicit comfort zone for the core CPI (2.5%).
Of even more importance, the core price index for Personal Consumption Expenditures (PCE) posted a 2.8% annualized gain in August and a year-over-year advance of 2.5% — well above the upper end of the acceptable range from the Fed’s point of view (about 2.0%).
The imputed “owners’ equivalent rent of primary residence” once again put perverse upward pressures on both the core CPI and the core PCE price index in August, as home buying continued to weaken and market rents firmed up further. But the core inflation numbers still were somewhat elevated, even after adjustment for this perverse upward pressure.
The Fed Is on Hold and Long-Term Interest Rates Are Receding, Despite Core Inflation Readings
Both the Federal Reserve and financial market participants have been able to stomach the recently elevated core inflation rates, relying on the evolving economic slowdown and retreating energy prices to relieve upward pressures on core inflation down the line. Indeed, measures of longer-term inflation expectations have been well-anchored in recent months despite the elevated inflation readings.
The statement released by the Fed at the conclusion of the Sept. 20 meeting of the Federal Open Market Committee (FOMC) noted the “elevated” readings on core inflation, but argued that “inflation pressures seem likely to moderate over time.”
That judgment allowed the FOMC to hold monetary policy steady for the second consecutive meeting, and it’s highly likely that the Fed will maintain the current target for the federal funds rate (5.25%) for the balance of this year and into 2007.
The economic slowdown, benign inflation expectations and the prospects for stable (or even easier) monetary policy have combined to produce an impressive bond market rally. Long-term bond and mortgage rates have come down substantially since mid-year, and those rates should remain close to current levels for some time.
Housing Demand May Be Stabilizing Following an Abrupt Downshift
The recent declines in interest rates and energy costs certainly are positives for housing demand, and home sellers now are offering a variety of price and non-price incentives to bolster sales and limit cancellations.
On the other hand, the slowdown in job growth is a negative for demand, measures of housing affordability still are running low and the lure of price appreciation is no longer driving demand by investors/speculators in single-family and condo markets.
Data on home sales for August contained some hopeful signals on the demand side of the markets, although it’s still too early to call an end to the downslide. The preliminary estimate of new-home sales for August (contract signings) was up by 4.1% from July. However, the data were revised downward for the May to July period, the trend in sales still appears to be downward and sales cancellations are not captured by this data system.
Sales of existing homes (closings) were down only slightly in August, with condos off by 3.5% and sales of single-family homes dead flat. “Pending” sales (contract signings) of existing single-family homes bounced back by 4.3% in August following an abrupt decline in July.
Price cutting by sellers of existing homes apparently is helping to stabilize sales activity following more than a year of decline, although one month of preliminary data hardly makes a trend.
Sobering signs regarding the condition of housing demand in September are provided by surveys of single-family builders and home mortgage lenders. The NAHB/Wells Fargo Housing Market Index slipped to a level of 30 in early September, the lowest reading since February 1991 (within the 1990-1991 economic recession). The index of applications for mortgages to buy homes (Mortgage Bankers Association series) was up by 3.3% in September, but still was down by 20% on a year-over-year basis.
Moreover, it’s entirely possible that the September bounce was a temporary event provoked by the unexpected decline in mortgage rates.
Inventory Overhangs Point Toward Further Declines in Housing Production
Although sales activity may have stabilized in August (at least temporarily), demand still is in a weakened condition and housing production is likely to decline further in the months ahead.
Available data show that the inventory of new and existing homes is at a record level, and those data exclude the market for new condo units as well as single-family homes that are left with builders due to cancellations of sales contracts — exclusions that undoubtedly lead to understatement of the degree to which the true inventory overhang has increased during the past year.
The single-family and condo markets also are vulnerable to an influx of “hidden supply” currently held off the market by investors/speculators that bought during the boom of 2004-2005 when ongoing price appreciation seemed like a sure thing.
NAHB’s forecast shows further declines in housing starts over the balance of this year and during the first half of 2007, and that pattern keeps the housing production component of GDP (residential fixed investment) on the decline through mid-2007. We’re counting on strong performances by other sectors of the economy, including construction of nonresidential structures, to keep the economy moving ahead reasonably well while the housing adjustment plays out.
 Attend the NAHB Construction Forecast Conference on Oct, 25
Don't miss NAHB's fall Construction Forecast Conference for the latest economic news about the housing industry.
Join NAHB on Wednesday, Oct. 25 for the Construction Forecast Conference — Fall 2006 in Washington, D.C.
Attend in person, or sign-up for the Webcast.
To register for either, visit www.nahb.org/cfc.
 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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