Fed's 'on-hold' decision focuses attention on slow homes market

Fed's 'on-hold' decision focuses attention on slow homes market
By Krishna Guha in Washington
Copyright The Financial Times Limited 2006
Published: August 14 2006 03:00 | Last updated: August 14 2006 03:00


The US Federal Reserve's decision to put interest rates on hold for the time being has focused attention on the downside risks to US economic growth from a rapidly slowing housing market.

The slowdown began a year ago but gathered pace in early spring, when all the main indicators of housing market activity turned decisively downwards. New single family home sales are now 11 per cent lower year on year, while sales of existing homes are down 8 per cent.

House price inflation has slowed sharply, and median house prices are now nearly flat year on year: rising 2 per cent for new homes and 1 per cent for existing houses.

This is not unwelcome news for the Fed, which is relying on a housing-led slowdown to slow growth and help bring down inflation. But the recent slowdown may have been a little sharper than the Fed expected.

Moreover, the stock of unsold houses relative to turnover has jumped - up 40 per cent for new and 47 per cent for existing homes - creating at least the risk of falling prices. This is compounded by the high proportion of buy-to-let investors and marginal buyers whose mortgage payments will go up. Certainly, the Fed cannot be sure how severe the slowdown will be.

There are two main channels through which the housing slowdown will effect growth: residential investment and consumption.

"From the growth point of view it is the new home sector that is the most important," since this drives residential investment, says Robert DiClemente, chief US economist at Citigroup, the banking group.

New home prices, which are more sensitive to inventory than existing home prices, could fall in absolute terms. Even if they do not, a sharp decline in residential investment is more or less guaranteed. The number of new building permits issued has fallen every month since February, and was down 15 per cent year on year in June.

Meanwhile, builders report a marked deterioration in business conditions, with the NAHB/Wells Fargo index down to 39 points from 70 a year earlier.

From 2003 to 2005 the residential investment boom added on average 0.48 percentage points to growth each year. Most economists now estimate it will subtract at least 0.5 percentage points from growth in each of the next three quarters.

A decline in residential investment, though, will already be factored into the Fed's benign central forecast of an economic soft-landing.

"The risks come more from the question of how the housing slowdown will spill over into broader consumption," says Larry Meyer, vice-chairman of Macro-economic Advisers, and a former Fed governor.

In the first instance, this will depend on what happens to the prices of existing homes. Here, there is tentative good news. While prices in some frothy regional markets have fallen in absolute terms, at the national level prices inched up each month from March to June. Most economists think prices will stagnate, rather than fall, in part while rents catch up.

This reflects a general view that while home prices are overvalued relative to fundamentals, they are not dramatically so across the nation as a whole.

Yet even if existing home prices merely flatten out, economists are divided as to how large an effect this would have on consumption.

"There are two main schools of thought," says Mr DiClemente. One emphasises the wealth effect of rising home prices on homeowners' consumption, the other the flow of funds from mortgage equity withdrawal.

Mr Meyer, who falls in the first camp, estimates that over the course of 2005 the wealth effect contributed 1.2 percentage points to consumption growth.

This year, assuming house prices are flat for the rest of the year, it will only contribute 0.2 percentage points, a decline of 1 percentage point. Many estimates incorporating an additional effect from mortgage equity withdrawal produce a still sharper consumption slowdown.

Yet some economists think both these approaches overstate the impact of house prices on consumption.

At the Fed, Alan Greenspan, former chairman, emphasised mortgage equity withdrawal, while Ben Bernanke, the new chairman, has put more weight on the wealth effect, telling Congress "increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past." Given all the uncertainties, it is not hard to see why the Fed wanted to pause and take stock of the data. Unfortunately, with inflation risks still on the upside, the Fed may not have the luxury of pausing for long.