Monday, November 06, 2006

Fed's Moskow on Housing

by Bill McBride on 11/06/2006 04:30:00 PM

Chicago Fed President Michael H. Moskow spoke today on the U.S Economic Outlook. Moskow focused on the housing market:

Residential investment has fallen 7-1/2 percent year-to-date, and in the third quarter it shaved 1.1 percentage points off of GDP growth. Additionally, home prices have been rising more slowly and by some measures have even declined. These developments raise important questions for the economy as a whole: Will there be further declines in housing markets? And will the current and any further declines in housing lead to more general economic weakness?

Here, it's important to remember the positive longer-run fundamentals underpinning housing demand. Since the mid-1990s, the housing capital stock—which reflects the number of homes in the U.S. as well as their size and quality—has been growing about 3 percent per year on average.

This demand for housing has been supported by the step-up in productivity growth, which improved the long-run income prospects for Americans. Furthermore, financial innovations lowered borrowing costs and greatly increased access to credit. As a result, the homeownership rate in the U.S. has increased from 64 percent in the mid-1990s to 69 percent in 2005, with improvements across nearly all demographic and income groups. And many people have put their money into bigger and better homes. Between 1995 and 2005, the size of a typical new home increased nearly 20 percent, and many homeowners invested in home improvements and renovations.

Nonetheless, with underlying housing demand growing 3 percent per year, the large gains in residential investment—which averaged 8-1/2 percent per year between 2001 and 2005—clearly could not continue indefinitely. Moreover, housing demand may slow to less than 3 percent, as demographics point to slower growth in household formation. As a result, we at the Chicago Fed expect some further weakness in residential construction.

By themselves, the declines in residential investment could contribute to some volatile numbers for overall GDP growth, as we saw in the third quarter. But their direct impact on the economy is limited by the relative size of residential investment. Home construction is on average only about 5 percent of GDP—that's about the same as people spend on recreation items such as books, golf clubs, and tickets to theater and opera.

Click on graph for larger image.

Moskow is correct that residential investment is on average around 5% of GDP (actually the median was 4.5% during the last 35 years). However, residential investment (RI) has recently fallen to 5.7% of GDP from the peak of 6.3% in the second half of 2005. So if RI falls back to the median level of the last 35 years (4.5% of GDP), the decline in RI has just started.
In order to generate more general economic weakness, the housing slowdown would have to spill over into other sectors of the economy. One avenue for this to occur is through home prices. We all know that home prices have soared during the past five years. The factors that caused fundamental increases in the demand for housing should be reflected to some degree in higher home prices. But there is still a risk that prices have also been boosted by factors unrelated to demand fundamentals. If that is the case, prices in some regions could unwind and reduce residential construction. And the negative wealth effects from softening house prices could reduce consumption more than anticipated.

Currently, we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy overall. On balance, the 95 percent of the economy outside of housing remains on good footing. emphasis added