by Calculated Risk on 10/03/2005 04:39:00 PM

"...make no mistake about it, the froth in the U.S. housing market is about to lose its effervescence; the bubble is about to become less bubbly. If real housing prices decline in the U.S. in 2006 or 2007, a recession is nearly inevitable." Bill Gross, PIMCO, October 2005

Here are two interesting perspectives on the economy going forward. The first is from Dr. Duy who ventures inside Greenspan's head: How Does the Fed See the Economy Evolving? And the second is from PIMCO's Bill Gross: Deliberate Acts Of Kindness.

Dr. Duy writes:

"... the Fed has shown concern that economic slack has evaporated, and, with rising energy prices in the background, inflationary pressures are building. To stem these pressures, they have tightened policy to reduce growth. They are not targeting the housing market directly, but recognize that since housing has been a driving force in the expansion, it will likely be the recipient of the brunt of their policy efforts.

A cooling of the housing market, however, is not undesirable, and a major decline in values is unlikely. ... And, under the Greenspan scenario, a housing slowdown is necessary to trigger a needed rebalancing of economic activity. Moreover, with excess slack drying up, some sector needs to pull back, especially with any sense of fiscal discipline long gone."

Of course this will lead to a slowdown in consumption, but Dr. Duy believes the Fed is looking for investment to fill the gap. The Fed's soft landing:

"The upshot it that the economy evolves in such a way that consumption slows, savings rises, and, as long as investment spending continues to grow, we avoid a recession."

Bill Gross is not quite as optimistic and summarizes his "sequence for house bubble popping or froth skimming" as:

1) Housing prices will cool/stop going up very much/even go down in some cities, WHEN...

a. Interest rates rise to a high enough level to make the purchase of a new home a burden instead of a boon for first time buyers.

b. Mild regulatory pressure begins to reduce the amount of funny-money lending.

c. Speculators sniff the beginning of the end.

2) Home equitization should retreat shortly thereafter.

3) Consumption/the U.S. economy will then weaken when the house ATM starts running out of fresh new $25,000/$50,000/$100,000 home equity loan dollar bills.

4) The Fed will cut interest rates in order to start the game all over again.

Let me state categorically that the above sequence is barely questionable, almost inevitable, 99% unavoidable, and in modern parlance - "slam-dunk." In so saying, I hope I am not being unkind to those of you who think otherwise - IÂ’m trying to do you a favor!

Mr Gross sees a recession as likely:

How weak the U.S. economy gets will depend on numerous factors: oil/natural gas prices, China's continuing growth miracle, and of course the level of U.S. interest rates - themselves a function of the Fed and foreign willingness to buy our Treasury and corporate bonds. But make no mistake about it, the froth in the U.S. housing market is about to lose its effervescence; the bubble is about to become less bubbly. If real housing prices decline in the U.S. in 2006 or 2007, a recession is nearly inevitable. If higher yields simply slow the pace of appreciation to a more rational single digit number, then we could escape with a 1-2% GDP economy.

The consistent theme is a slowing housing market and the questions are: What will the housing slowdown look like? And how large an impact will that have on US economic growth?

If the housing slowdown is gradual, and investment can replace the lost consumption associated with equity extraction, GDP growth will slow but the economy will stay healthy. Savings will rise, the current account deficit will fall and Americans will all hold hands and sing Kumbaya. Very unlikely in my view for several reasons:

1) The excessive leverage and speculation in the housing market means achieving a soft landing is very difficult. Many recent buyers will be hurt if house prices just flatten, making the FED's job very difficult.

2) The transition from a housing centric economy to a more balanced economy will involve significant dislocations. Many jobs in the housing related industries have non-transferable skills, require low levels of education, and are relatively well paying. These jobs will be difficult to replace.

3) The lowering of US consumption will have a worldwide ripple effect and especially impact China and other countries currently running trade surpluses with the US. These countries will probably sell US assets for domestic purposes (to minimize economic weakness) leading to higher rates in the US - exacerbating the US housing slowdown.

I'm sure I've left off several other problems (I need to read Dr. Setser and Dr. Kash Mansori). As much as I would like to see a soft landing, I think a hard landing is very likely.

NOTE: Please read Dr. Duy's piece - it is excellent. Also, Gross' piece starts with a nice tribute to his wife and the wonders of kindness in our everyday life.

Best to all.