Observations and Predictions for 2006

by admin

By David F. Seiders, Chief Economist, National Association of Home Builders

National Economic Expansion Still Intact
The 2001 economic recession is now four years behind us, and growth of U.S. economic output (real GDP) has been quite good for the past three years. The economy also has shown an impressive ability to shake off serious shocks, including the unprecedented hurricane season last fall.

We’re now in the “middle innings” of the current economic expansion, and the next economic recession is not yet in sight. Gathering forward momentum in the global economy, along with reassuring developments in world energy markets, bode well for the U.S. economy down the line.

Economy Not Generating Serious Inflation Pressures
The U.S. economy had an uncomfortable brush with deflation (falling prices) in 2003. The strengthening of economic growth and job formation since then has lifted “core” inflation rates (excluding prices of food and energy) into a higher zone, although recent rates still are quite low on an historical basis.

Rising labor costs, along with some inevitable pass-through of high-energy costs, are likely to place some additional upward pressure on core inflation in 2006. However, core consumer price inflation should not move above the upper end of the Federal Reserve’s apparent “tolerance range,” and overheating is not a proximate threat to the U.S. economic expansion.

Federal Reserve Nearing End of Rate-Hike Cycle
The Federal Reserve cut short-term rates aggressively to limit the 2001 recession, support the early stages of economic expansion, and fight off the deflation threat in 2003. The Fed started to withdraw monetary stimulus from the economy at mid-2004 and has raised short-term rates by a cumulative 3.25 percentage points since.

The Fed wants to get monetary policy into a “neutral” position (neither stimulating nor impeding economic growth), and minutes from the last Federal Open Market Committee (FOMC) meeting on Dec. 13 show that policymakers believe that process is nearly complete. Another quarter-point rate hike is likely at the next FOMC meeting on Jan. 31 (Fed Chairman Alan Greenspan’s last meeting), and monetary policy most likely will be held steady during the first year of Ben Bernanke’s tenure as Fed Chairman.

Home Sales, Housing Production Will ‘Simmer Down’
The retreat in housing market activity that’s now underway amounts to a “simmering down” process from unsustainably hot market conditions in 2005, rather than a classic cyclical contraction that could spiral downward for some time. The projected economic and financial market conditions discussed above are key to this favorable outcome for housing.

NAHB’s housing forecast for 2006 shows home sales and conventional housing starts coming off the 2005 highs but remaining comparable to the excellent performances of 2004. In the process, home price appreciation is expected to slow down considerably but remain comfortably in the positive zone.

Some components of housing production will show ongoing real (inflation-adjusted) growth in 2006, including shipments of manufactured (HUD-code) homes, residential remodeling and starts of market-rate rental housing. Everything considered, the housing production component of GDP (residential fixed investment) will transition from a powerful economic growth engine to a slight drag on GDP growth.

Economic and Housing Market Performances Still Vary Geographically
The 2001 recession was concentrated in the manufacturing sector of the economy and in the geographic areas with heavy concentration in manufacturing, particularly the industrial Midwest. Indeed, the job market in Michigan contracted in 2005 for the fifth consecutive year, and employment levels in Ohio, Illinois and Indiana, are still well below pre-recession peaks.

Housing markets performed surprisingly well in hard-hit economic areas, at least through 2004, as the historically low interest rate structure fueled home buying by renters and trade-up activity by homeowners with jobs. But the weight of cumulative job market losses took a serious toll on Midwest housing markets in 2005, even as the national market soared to new record highs.

Another year of national and global economic expansion, along with a lower dollar, should help firm up the Midwest economies in 2006, although the higher national interest rate structure and persistent out-migration from the Midwest region will keep housing markets in that part of the country relatively weak for some time.

Downside Risks to Economy Reside Within Housing Sector
The housing sector has made unprecedented positive contributions to U.S. economic growth in recent years. These contributions have come through two major channels:

• Home sales, housing production and stimulus to industries closely related to housing market activity
• Rapid rates of house price appreciation that generated huge amounts of housing equity that, in turn, stimulated consumer spending and allowed households to run current saving to zero or below (via borrowing and spending beyond current income).

The recent surges in home sales, housing production and home prices were related partly to surges in investor/speculator activity in single-family and condo markets. Furthermore, proliferation of “exotic” forms of adjustable-rate mortgages helped fuel buying by marginal homebuyers as well as by investors/speculator looking for quick capital gains.

It’s possible that quick reversal of these special factors could badly weaken housing markets, send investors/speculators scurrying to the sidelines, provoke sizeable house price declines, cut into housing equity and provoke a snapback in the personal saving rate that would cut seriously into consumer spending. But the probability of such an outcome is quite low, and the orderly cooling process that’s now underway is in line with the “simmering down” pattern in NAHB’s forecast.

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