Eye on the Economy: Housing Recovery Will Begin in 2008

Growth of U.S. economic output (real GDP) was remarkably strong in the second and third quarters of this year, averaging 4.4 percent for that period. This strong performance was registered in the face of a heavy drag from the downswing in housing production as well as substantial turbulence in credit markets associated with deepening problems in the subprime mortgage market.

But the economy has hit a “rough patch” in the final quarter of 2007, and the probability of near-term economic recession has moved up in the process.

Economic Recession Most Likely Will Be Averted

The late-2007 downshift in economic growth reflects, to some degree, inevitable weakening of some GDP components, exports and business inventory investment that displayed temporary growth spurts in the third quarter.

Furthermore, the housing downswing has continued to deepen and the fourth-quarter hit to GDP growth is likely to be even heavier than in the third quarter.

Finally, we’re now looking at a substantial unanticipated slowdown in growth of consumer spending, a sector that accounts for about 70 percent of total GDP.

Everything considered, we’re now estimating GDP growth of only 0.5 percent in the fourth quarter, not far from the recessionary red zone, and we’re also projecting decidedly subpar growth early next year.

Indeed, we’re now pegging the probability of economic recession within the next 12 months at 40 percent, up from 30 percent a month ago, and we believe that monetary stimulus by the Federal Reserve will be needed to keep the economy in the black during the coming year.

Mortgage Problems Weigh Heavily on the Housing Market

Interest rates on prime conventional conforming mortgages — those salable to Fannie Mae and Freddie Mac — recently have fallen to historically low levels, and the FHA mortgage insurance program has been growing at the same time.

But the nonprime components of the mortgage market, subprime and Alt-A, still are nonfunctional and yield requirements in the prime jumbo market (above the $417,000 conforming loan limit) are prohibitive for many prospective buyers in California and other high-priced housing markets.

Lending standards have been tightening throughout the mortgage market, making it tougher for prospective home buyers even in the prime components of the market where interest rates are favorable.

This tightening process has effectively eliminated earlier “affordability” products, including interest-only and payment-option adjustable-rate loans. The process also has pulled back low/no documentation loans as well as piggy-back seconds that had proliferated during the boom.

NAHB’s surveys of builders continue to document serious adverse impacts of tightening mortgage lending conditions on home sales and sales cancellations. These impacts definitely are showing up in the standard measures of new and existing homes sales.

The downtrend in sales continued through October and we expect further slippage in both gross and net sales into the early part of next year prior to an extended recovery process.

Excess Supply Still Hangs Over Housing Market

Single-family housing starts are down by about 50 percent from the record high at the beginning of last year, and starts for-sale (excluding units built on owners’ lots) are down by even more. Unfortunately, home sales also have fallen dramatically and sales cancellations have been boosted by the tightening of mortgage market conditions.

Furthermore, investors/speculators have been unloading many units bought during the boom, but never occupied, onto the market for existing homes.

In the existing-home market, a near-record 3.8 million homes were for sale at the end of October, amounting to a record 10.5 months supply at the October sales pace.

In the new-home market, 516,000 units were for sale at the end of October, down to some degree from the record highs of last year but still a historically high 8.5 months supply. The estimate of new-home inventory excludes homes handed back to builders when sales contracts are cancelled — a major market development in both 2006 and 2007.

The heavy supply overhang points toward further reductions in the pace of new housing starts in the near term, and the ensuing upturn in starts will lag the upturn in sales by several quarters.

Furthermore, the supply-demand imbalance will continue to put downward pressure on house prices in some areas, particularly those that got seriously overheated during the boom stage of the housing cycle and areas where local economies have been losing both employment and population for some time.

The Fed Is Prepared to Ease Monetary Policy

The Fed enacted quarter-point cuts in both the federal funds rate target and the discount rate at the conclusion of the Oct. 31 Federal Open Market Committee (FOMC) meeting. At that time, the FOMC expressed the judgment that “after this action, the upside risks to inflation roughly balance the downside risks to growth.”

But the obvious slowdown in economic growth since then, coupled with renewed turbulence in credit markets, has forced a major change in the Fed’s view of near-term risks to the U.S. economy.

In late November, both Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn delivered addresses that revealed increasing concern about downward pressures on economic growth, coming largely from the housing sector, as well as renewed turbulence in financial markets, coming largely from the subprime mortgage market.

Both Bernanke and Kohn referred to spillover effects from housing and mortgage markets to the broader economy and to other components of the credit markets — including the commercial paper and corporate bond markets. And neither fretted about upside risks to core inflation in the foreseeable future.

It’s now highly likely that the Fed will enact additional cuts in the federal funds and discount rates at the next FOMC meeting on Dec. 11, and further monetary ease is likely early next year as well.

NAHB’s current forecast assumes quarter-point rate cuts at both the Dec. 11 and Jan. 31 FOMC meetings, and a half-point cut this week is not out of the question. Deeper rate cuts early next year also are possible if evidence shows the economy slipping toward recession.

The Housing Recovery Will Begin in 2008

The dramatic housing downswing that began in the latter part of 2005 has already dropped national home sales and housing production well below pre-boom levels, and the bulk of the downswing presumably is now behind us.

Sales and production for 2008 as a whole most likely will turn out to be below the 2007 totals, but crucial turning points are likely to be registered during the year — assuming the Fed keeps us out of recession and mortgage markets function more normally.

NAHB’s current forecast shows troughs for sales of both new and existing homes in the first quarter of 2008. In view of the inventory overhang, we don’t expect housing starts to start upward until the third quarter of the year.

Given normal lags, the housing production component of GDP (residential fixed investment) should be only a minor drag on economic growth by late next year and should begin to register positive growth by the first quarter of 2009.

-NAHB Chief Economist David Seiders