In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Wednesday, March 12, 2008

The impact of Declining House Prices on Consumption

by Calculated Risk on 3/12/2008 12:23:00 PM

Here are two rough methods to estimate the impact of declining house prices on personal consumption expenditures (PCE). The first uses Mortgage Equity Withdrawal (MEW) and estimates the portion of the "Home ATM" that is consumed. The second is an estimate based solely on the changes in house prices (See: Carroll, Otsuka, and Slacalek, How Large Is the Housing Wealth Effect? A New Approach October 18, 2006).

The following graph shows MEW (provided by the Fed's Jim Kennedy based on the mortgage system presented in "Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences," Alan Greenspan and James Kennedy, Federal Reserve Board FEDS working paper no. 2005-41.)

Kennedy Greenspan Mortgage Equity Withdrawal Click on graph for larger image.
According to Dr. Kennedy's analysis, MEW in 2006 was $680 billion, and declined to $464 billion in 2007. Greenspan estimated that approximately 50% of MEW is consumed, and it is probably consumed over several quarters. We can estimate that perhaps half of the $216 billion decline in MEW (or $100 billion) is the drag on PCE in 2007 and early 2008 from declining MEW.

With tighter lending standards, and falling house prices, MEW will probably decline sharply in 2008. Imagine if MEW falls to $100 billion; a decline of $364 billion from 2007. That would be a drag of $180 billion or so on PCE.

Carroll, et. al, estimated:

"In U.S. data, we estimate that the immediate (next-quarter) marginal propensity to consume from a $1 change in housing wealth is about 2 cents, with a final longrun effect around 9 cents."
Imagine house price declines of 10% in a given year. With total household real estate assets of approximately $20 Trillion (Fed's Flow of Funds report, Table B.100, line 4), a 10% decline in house prices would reduce household wealth by $2 trillion. Using Carroll's long run estimate of 9 cents per $1 change in the marginal propensity to consume, gives a drag on PCE of about $180 billion.

Let's use the $180 billion as the drag on PCE in 2008. This is a large number, but we have to put that number into perspective. From 2006 to 2007, nominal PCE increased by $508 billion (See BEA GDP report line 2).

So perhaps declining house prices will reduce the increase in PCE from $500 billion to closer to $300 billion in 2008 (in nominal terms), and perhaps PCE will decline in real terms (adjusted for inflation), but the impact probably isn't large enough to reduce nominal PCE.

Although the impact on PCE from declining house prices will probably be significant, the size of the impact is not huge when compared to the overall U.S. economy. This is one of the reasons I think the recession will not be severe (unemployment will not rise to 8%), although I do expect the slowdown to linger, and the recovery to be sluggish (because housing will not be an engine of recovery this time).