Housing Economics - 11/17/2006

• Growth of U.S. economic output (real Gross Domestic Product) slowed down further in the third quarter as the housing production component (Residential Fixed Investment) subtracted more than a percentage point from the overall GDP growth rate. Further below-trend GDP growth is in the cards for the fourth quarter of the year, due largely to another sizeable negative contribution from RFI, but the drag from housing should ease off early next year and the economy should easily avoid recession in 2007.

• Despite preliminary indications of relatively weak payroll job growth last month, including further slippage of the residential construction component, the October employment report was fundamentally strong. The report included large upward revisions to payroll employment growth in both August and September, maintenance of strong growth in average hourly earnings, and strong growth in both the labor force and household employment —along with a decline in the unemployment rate to a new cyclical low in October.

• The combination of slowing GDP growth, solid job growth, shrinking slack in labor markets and upward momentum in average hourly earnings has sobering implications for both labor productivity (output per hour) and unit labor costs. Indeed, slowing productivity growth and rising unit labor costs are already in evidence, and continuation of those patterns would have sobering implications for business profit margins and for the inflation picture in the U.S.

• Core consumer price inflation still is running above the upper bounds of the Federal Reserve’s implicit tolerance ranges, largely because of the influence of the government’s imputation for “homeowners’ equivalent rent.” It’s still reasonable to expect core inflation to recede as the below-trend economic expansion proceeds and upward pressures on market rents abate, although that picture has been clouded by the recent slowdown in productivity growth and the renewed upward pressure on unit labor costs.

• The Federal Reserve held monetary policy steady at the October 24-25 meeting of the Federal Open Market Committee (FOMC), stressing the importance of a “cooling” housing market in the current slowdown of economic growth and projecting moderation of core inflation from recent “elevated” levels. The Fed is likely to hold policy steady into 2007 despite the recent troubling news on productivity growth and unit labor costs, and we’re still expecting a bit of monetary easing around mid-2007.

• The employment report for October (released on November 3) provoked immediate increases in long-term interest rates as inflation expectations in financial markets were marked up and prospects for near-term Fed easing were marked down. Even so, long rates remain well below their mid-year highs, and the outlook for Treasury bond and long-term mortgage rates remains quite favorable in the context of our projections for real economic growth, core inflation and Fed policy.

• Home sales still appear to be trending downward from the unsustainable levels recorded in 2005 and sales cancellations still are a major issue. However, forward-looking indicators suggest that stabilization of home buyer demand is likely to occur in the near future. Indeed, a number of key economic and housing market developments now are underpinning housing demand, and many home sellers (particularly home builders) are trimming prices and offering a plethora of non-price sales incentives.

• The inventories of unsold single-family homes and condo units have edged down a bit from recent records, but inventory levels and inventory-to-sales ratios still are quite high. Furthermore, inventory overhands undoubtedly are larger than shown by published data and vacant units now account for an unusually large share of homes for sale. The weight of the inventory situation is likely to exert downward pressure on new housing production and home price appreciation for at least a few more quarters.

• NAHB’s housing forecast shows a trough in home sales in the first quarter of 2007, a trough in housing starts in the second quarter, and a bottoming-out of home price appreciation in the second half of 2007. The projected recovery process lifts home sales and housing production back up toward trend by the end of 2008, and national house price appreciation should be comfortably in the positive zone by then.

• The recent and projected housing “correction” is roughly half as long and deep as the housing downswing that accompanied the 1990-1991 economic recession, and the overall economic environment is likely to remain relatively positive as this housing downswing plays out. Indeed, this housing correction has been a relatively isolated sectoral event provoked by earlier excesses within the sector— including a massive influx of investors/speculators that drove home sales and home prices to unsustainable heights and decimated affordability conditions.

• The outcome of the November 7 Congressional elections does not significantly alter the economic and housing outlook for 2007-2008. The independent Federal Reserve will hold the major policy lever during that period, and major decisions on things like Social Security and tax reform will not occu r prior to the 2008 elections.