Eye on the Economy: The Inventory Overhang Is Heavier Than It Looks
Growth of U.S. economic output (real Gross Domestic Product) has slowed from the above-trend rates recorded earlier in the expansion, although overall GDP growth has held up reasonably well in recent quarters even as the housing production component (residential fixed investment) has contracted substantially.
Furthermore, the contraction in housing market activity and the slowdown in house price appreciation have not generated serious “spillover” effects in other sectors of the economy (including personal consumption expenditures), and strengthening activity in some sectors (including nonresidential construction) has helped offset the negatives from housing production.
As a result, the economy did not skate close to recession in 2006 and the probability of an economic downturn is not high during the 2007-2008 period.
Economic resilience also is evident in the labor market. The housing downswing caused job losses in residential construction during most of 2006 and into January of this year, and further losses in construction are inevitable during coming months.
However, overall job growth was reasonably well maintained in 2006 and we’re expecting a solid performance in 2007 as well. The unemployment rate ticked up in January to 4.6% and is likely to gravitate upward somewhat further. However, we do not expect the unemployment rate to rise above 5% during the 2007-2008 period.
Core Inflation Has Begun to Recede
Key measures of core consumer price inflation (excluding prices of food and energy) firmed up during much of 2006, moving well above the upper bounds of the Federal Reserve’s apparent “tolerance zones.”
This inflation pattern naturally raised concerns at our central bank about potential economic “overheating” and prompted many financial market participants to anticipate some tightening of monetary policy in the near term.
As 2006 drew to a close, core inflation rates began to recede, at least on a year-over-year basis. The core Consumer Price Index slowed systematically during the fourth quarter, receding to a pace only slightly above the upper bound of the Fed’s apparent tolerance zone for this measure. Even more important, the core price index for Personal Consumption Expenditures — the Fed’s favorite inflation gauge — displayed the same type of pattern.
The evolving slowdown in core inflation had been projected by the Federal Reserve, and this pattern is an integral part of NAHB’s forecast for 2007 and 2008. The recent and projected improvements on the inflation front reflect modest slowdowns in growth of real GDP and employment as well as dissipation of some special factors that elevated core inflation last year.
On the latter point, the “owners’ equivalent rent” component of the core price measures has slowed to some degree and figures to contribute to the projected slowdown in core inflation in 2007-2008.
The Fed Is Anchoring the Interest Rate Structure
The Federal Reserve held monetary policy steady at the Jan. 30-31 meeting of the Federal Open Market Committee (FOMC). Indeed, the Fed has held its target for the federal funds rate at 5.25% since mid-2006, a level that’s around a “neutral” monetary policy stance in the prevailing inflation environment.
We expect the Fed to maintain this funds rate target until the late-June FOMC meeting, and we still anticipate a quarter-point rate cut at that time — in order to keep the “real” funds rate from rising as core inflation recedes.
Long-term interest rates firmed up to some degree in late January and early February as incoming data on the economy were surprisingly strong, but long rates have receded more recently. The long-term home mortgage rate is hanging around 6.25%, the same as a year earlier and half a percentage point below the mid-2006 level.
The Treasury yield curve still is inverted across much of its range, a pattern that may not be sustainable for much longer. NAHB’s forecast shows an essentially flat Treasury yield curve by late this year, at least out to the 10-year mark, as short rates recede a bit and long rates move up modestly from current levels.
In this regard, we do not expect the long-term mortgage rate to move above 6.5% this year.
Housing Demand Has Stabilized Following an Abrupt Downward Correction
A healthy job market, good growth in household income, a favorable interest rate environment and receding energy costs provided support to housing demand in the latter part of 2006. Furthermore, widespread cuts in house prices and deepening nonprice sales incentives (documented by NAHB surveys) gave further support to demand as last year drew to a close and 2007 got underway.
Despite formidable seasonal adjustment issues, housing demand apparently stabilized in fundamental terms toward the end of 2006, and some improvement now seems to be underway.
Indeed, the Jan. 31 FOMC statement cited “some tentative signs of stabilization” in the housing market — in sharp contrast to the reference to “substantial cooling of the housing market” in the Dec. 12 FOMC statement — and Fed Chairman Ben Bernanke repeated that assessment in his Feb. 14-15 testimony that conveyed the central bank’s semiannual Monetary Policy Report to the Congress.
The fourth-quarter averages for sales of both new and existing single-family homes were up a bit from their third-quarter averages. Furthermore, NAHB’s single-family Housing Market Index (HMI) — incorporating survey readings for current and expected home sales as well as for traffic of prospective buyers has continued to move upward (the February HMI came to 40, up from a low of 30 last September).
The weekly series on applications for mortgages to buy homes by the Mortgage Bankers Association, available through early February, also supports the proposition that housing demand has stabilized, despite well-known seasonal adjustment issues with this series. And as Bernanke told Congress this week, measures of home buyer sentiment recently have been on the rise.
NAHB’s proprietary monthly survey of 30 large home builders — accounting for about one-fourth of the total for-sale new home market — also provides some reassuring signals on the demand side of the single-family market during the final months of 2006 and into January of this year. These data (seasonally adjusted by NAHB) show a distinct falloff in cancellations and stabilization of net sales since the middle of last year.
The Inventory Overhang Is Heavier Than It Looks
Stabilization of housing demand (net sales) is the essential first step toward completion of the dramatic housing “correction” that has followed the unsustainable housing boom of 2004 to 2005.
The second step is to work down an excessive inventory overhang in markets for both new and existing housing, and the final step is to bring housing starts and residential construction activity back up to sustainable trend levels.
The inventory overhang in the markets for new and existing single-family homes came down a bit in the final months of 2006, at least according to the standard measures. However, inclusion of homes left with builders through sales cancellations, along with consideration of an elevated level of vacant for-sale homes in the existing housing stock, show that the inventory overhang is heavier than it appears at first glance.
The current overhang of vacant homes for sale (new plus existing) may not be the end of that story. The single-family rental vacancy rate recently climbed to a record level, presumably reflecting difficulties being encountered by investors that are biding their time before putting single-family homes back on the market.
It’s hard to estimate the numbers of single-family rental units that will become for-sale units, or the time frames involved, but builders should listen for this shoe to drop. There’s also the issue of competition from the multifamily condo market, where the number of vacant for-sale units (new and existing) has climbed even more dramatically (in percentage terms) than in the single-family market.
Housing Finance Excesses Are Coming Home to Roost
The relaxation of mortgage lending standards that helped fuel the unsustainable housing boom of 2004 to 2005 has been coming home to roost in the form of rising delinquency and default rates, particularly in the subprime market.
So far, the reflow of foreclosed homes back onto the for-sale market has been quite limited in most areas, and we’re not expecting this factor to seriously aggravate the overall supply-demand balance in single-family or condo markets over the course of the next two years.
The well-publicized problems in the subprime mortgage market and related mortgage-backed securities markets, the supervisory guidance recently issued by federal and state regulators of depository institutions regarding “nontraditional” adjustable-rate mortgage products, and an expanding focus by the Congress on “predatory” lending practices and home foreclosures are combining to cause a swing back to firmer home mortgage lending standards than had prevailed during the boom period.
While significant, we do not expect this shift to forestall the improvements in home sales and housing starts shown in our forecasts for 2007-2008.
The Projected Upswing in Housing Production Is Fighting Some Strong Headwinds
NAHB’s baseline (most probable) forecast anticipates an upturn in national housing starts by the second quarter of this year and a turnaround in residential fixed investment (in the GDP accounts) by the third quarter.
The forecast also depicts a gradual recovery in national housing production through 2008 as housing starts approach our estimate of sustainable trend — about 1.85 million units per year.
NAHB’s baseline housing starts forecast stands somewhat above the February Blue Chip consensus forecast, particularly for 2008 — 1.71 million units vs. 1.60 million units — and it’s fair to say that there’s considerable downside risk to our forecast. Indeed, Bernanke just told the Congress that, from the Fed’s perspective, “the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate.”
We’re all struggling to assess the aftermath of the unique investor-driven housing boom, the uncertain dimensions of the inventory overhang (including the vacant unit issue) and the degree of backlash in the housing finance system following the earlier relaxation of lending standards. We’ll be constantly reassessing the various “headwinds” encountered by the incipient housing recovery as we move ahead. Stay tuned.
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 Feb. 14 edition. To subscribe to “Eye on the Economy,” click here.
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NAHB Kit Gives Builders Back-to-Basics Tips in Cooling Market
With the current cooling of the nation’s housing market expected to persist into the middle of the year, NAHB has developed a comprehensive online toolkit geared to providing association members with information that will help them prosper in today’s changing business environment.
To access the “Back to Basics” toolkit, you must be an NAHB member and have a login to www.nahb.org. To create a login, go to www.nahb.org/login or click on the log-in button on the main menu bar.
For assistance, call the NAHB Member Service Center at 800-368-5242.