by Calculated Risk on 10/17/2006 12:18:00 AM

In the previous post I quoted from San Francisco Fed President Yellen's speech today. Of all the Fed Presidents and FOMC members, Dr. Yellen has consistently been the most bearish on housing; and therefore, at least so far, the most prescient of the Fed Presidents. As an example, see her speeches from July and October of 2005 - with comments like:

"...analyses do indicate that house prices are abnormally high—that there is a "bubble" element."

At the other end of the spectrum is Jeffrey M. Lacker, President of the Federal Reserve Bank of Richmond. Dr. Lacker is the most hawkish member of the FOMC, and Lacker dissented at the last two FOMC meetings:

Mr. Lacker dissented because he believed that further tightening was needed ...

Apparently Dr. Lacker is more optimistic about the housing market. From his speech on October 11th (hat tip: Kevin):

It’s important to remember that the recent housing market boom was driven by fundamental factors that were — and still are — quite favorable. I’ll just briefly list a few for you. Population continues to expand; for example, last year the number of households increased by 1 percent nationwide. Income is growing — so far this year, inflation-adjusted disposable income per person has increased at a 2.8 percent annual rate. We are a wealthy nation; household net worth is 53 trillion dollars, which represents over five-and-a-half years of disposable personal income. The tax treatment of housing remains highly favorable. Finally, mortgage interest rates were extremely low for many years, and even now are quite reasonable by historical standards.

... With the surge in demand apparently satisfied now, we can expect to see a “return to normalcy” in the housing market, if I can borrow a phrase from a former Washington resident. Such a return to normalcy would involve lower production than we saw at the peak, and certainly a lower trajectory for housing prices.

This transition in the housing market is well under way. New home sales are down 17 percent, housing starts have fallen 20 percent, and the rate of price appreciation has fallen substantially, to the point that average prices were slightly lower in August than they were a year ago. These are national figures, of course, and more dramatic swings can be seen in some localities, particularly in areas that saw the strongest increases in housing prices and activity. ...

At the national level, some further retrenchment in housing markets is likely in the months ahead. But while there is substantial uncertainty about where the bottoming out will occur, I don’t think a catastrophic collapse in housing activity is likely, since the fundamental determinants of housing demand that I listed earlier remain favorable: prospects for population and real income growth look good, net worth remains high, and after-tax mortgage interest rates are still historically low. Instead, I believe we are seeing a return to a more conventional level of housing market activity in which volume, inventories and time-on-market are closer to historical averages. This adjustment naturally involves a fair amount of uncertainty for market participants. Both buyers and sellers are probably more unsure than usual right now about where prices need to settle in order to clear markets. In the meantime, they are collectively engaged in a time-consuming process of discovering the prices at which expectations and plans of buyers and sellers are mutually consistent.

Many macroeconomic analysts are concerned about the potential fallout of a weakening housing market. The direct impact of the housing market on overall economic activity is easy to calculate. The measure of residential investment spending that is included in real GDP has now fallen for three consecutive quarters. In the second quarter it fell at an annual rate of 11.1 percent, and appears likely to decline even more rapidly in the second half of this year. Since residential investment accounts for less than 6 percent of GDP, that lowered the real GDP growth rate by about seven-tenths of 1 percent in the second quarter. It would not be surprising to see housing reduce growth by even more for a few quarters. That would be a significant drag on the economy, but it would not end the expansion either, especially in light of offsetting strength in business investment spending, a topic I will touch on later.

While the direct effect of housing on GDP may not be overly large, some analysts worry about indirect effects, such as lower housing wealth leading to lower consumer spending. Again, it’s important to begin with fundamentals. While fluctuations in household wealth are capable of affecting spending at the margin, the behavior of consumers is predominantly determined by their current and future income prospects. And those prospects are looking pretty good right now. With the unemployment rate below 5 percent, the labor market is looking fairly tight right now. Despite large increases in gasoline prices earlier this year, inflation-adjusted incomes are rising, as I noted earlier. And now that we’ve seen some relief at the gas pump, it would not be surprising to see a modest pickup in real income growth in the next couple of months.

The deceleration and fall in housing prices certainly will cut in to household net worth to some extent, but so far, such wealth effects have done little to slow household spending.

Could housing prices end up falling sharply enough to cause consumers to rein in spending? Perhaps, but consumers’ balance sheets generally are not as fragile as some commentary might lead one to believe. Housing debt is only 44 percent of the value of household real estate. With that substantial equity position, most homeowners who are not planning to move for other reasons can pretty much ignore transient price fluctuations. And with relatively high levels of financial net worth, most households are well buffered against price fluctuations. Moreover, as I emphasized earlier, household spending is driven mainly by current and future income prospects. Taking all these considerations into account, I would look for consumer spending to continue to expand at a reasonably good pace, even if housing prices come in weaker than I expect.

I should note that the end of the housing boom could not have been a complete surprise to most participants. Sure, it’s nice to sell your home when bidding wars and escalator clauses are common, as they were in 2005. But these conditions were fairly unusual in most markets, and it’s hard to believe many people seriously thought they would persist indefinitely. This is another reason to believe that most people are likely to be reasonably well-positioned for the end of the boom.

Another potential spillover that some analysts like to mention involves mortgage lending, especially with new financing options available to consumers. My sense is that the underwriting and pricing of mortgages has on the whole been sound, despite some individual anecdotes that suggest otherwise. The broad range of households that have taken out nontraditional mortgages are going to find them advantageous, even if, as with many financial products, a small fraction end up regretting their choice after the fact. Moreover, the banking industry looks healthy right now, with strong profitability and high levels of capital. Loan delinquencies are quite low by historical standards, as are chargeoffs of real estate loans. So it looks to me as if the end of the housing boom is unlikely to have any broader spillovers as a result of financial repercussions. Nor is it likely to be exacerbated by financial disintermediation of the type we saw earlier in the postwar era.

The labor market is another potential arena for adverse spillover effects from the housing market. We have seen employment in the residential construction sector fall this year as residential building activity has declined. Fortunately, however, nonresidential construction is on an upswing — over the four quarters ending in June, real nonresidential investment rose 7.2 percent. Further increases in nonresidential construction will allow many workers to simply change construction jobs rather than become unemployed. Indeed, over the last year overall construction employment has actually risen by nearly 210,000 jobs even as housing activity has softened.

As I mentioned earlier, the expected further weakening in housing activity is likely to be largely offset by business capital spending. Over the last three years, business fixed investment has grown at a quite solid 6.6 percent annual rate. Since business fixed investment is over 10 percent of GDP, this means that is has added about two-thirds of a percentage point to GDP growth, which has counteracted the drag from housing that I cited earlier. Indeed, when business investment demand fell sharply following the technology boom of the late 1990s, and the FOMC lowered interest rates in response, the anticipation was that interest rate-sensitive sectors such as housing and consumer durables would take up some of the slack until business investment spending rebounded. Now that business investment has substantially recovered, it makes sense for housing activity to subside in turn.

I disagree with Lacker on several points. As I've noted before, demographics are actually somewhat unfavorable for housing as compared to earlier periods. And the inflation adjusted disposable income per person only increased 1.9%, not 2.8%. This is also the wrong number to use for analyzing the housing market; the top income earners could have had a good year and that would skew the average.

Note: to check the DPI per capita number use this table from the BEA. Line 37 is the inflation adjusted DPI per capita. For Q2 2005, DPI per capita was $27,290, for Q2 2006: $27,801.

I'll address Lacker's arguments in a future post.