Economic Commentary: Varying Signs

by Lawrence Yun, NAR Chief Economist

These last few months saw a “pause” in housing market activity following the rush of buyers to qualify for the tax credit. That pause was anticipated – and is still occurring. Contract signings on existing homes fell 3 percent in June; that on top of the 30 percent tumble in May. July data is still being collected; unfortunately the raw data coming are not encouraging and could be similarly low. The pause, we hope, will not extend into the autumn months. If it does, home prices could indeed take another tumble down after essentially stabilizing over the past 18 months. Others are certainly taking note. The former Fed chairman, Alan Greenspan, said on one recent Sunday morning “talking head” show that the broader economy will surely go into another recession if home values were to fall. Meanwhile, the current Fed chair, Ben Bernanke, spoke of an ‘unusually uncertain’ economic outlook.

Whatever current or former Fed chairmen say, most observers and analysts of the housing market say the same thing: it depends on jobs. The housing market will surely regain traction sooner and be on firmer footing once the economy adds jobs at a good pace. The importance of job creation is evident in local markets like the Washington D.C. region, the Boston market, and the Houston market. In those areas, job markets are expanding and home sales are now, even without the tax credit having expired, matching up with last year’s levels.

But one’s outlook depends on how one interprets the signs. Does the housing market depend on signs from the economy or does the economy, as stipulated by Mr. Greenspan, depend on signs from housing? Former Chairman Greenspan has been a big proponent of the importance of asset value changes on the economy. Rising home value will mean increased housing wealth accumulation, will greatly improve the financial conditions of home-owning families and financial institutions and mean a greater capacity for the economy to grow. Vice versa when home prices fall. According to the Federal Reserve, the net worth of real estate assets held by households increased $453 billion in the past four quarters. However, what is disconcerting at the moment is the near stalling of the broader economy even though home prices have held steady.

Gross Domestic Product (GDP), which measures total production in the economy, decelerated to 2.4 percent in the second quarter after growing 3.7 percent and 5.0 percent in the prior two quarters. After a deep recession, the economy – based on historic patterns -- should have bounced back at a growth rate of near 5 percent. When one delves deeply into the sources of economic growth, one finds an unusual mismatch between what the level of business spending should be versus what it has been. Let’s review what we know of each of the GDP components in real dollars above inflation:

• Consumer spending has been rising at a 2 percent rate rather than a 4 percent growth rates prior to the recession. This is expected and will likely continue at such a subdued pace for the next two years given consumers have been tapped out and need to rebuild their savings.
• State and local government spending has been falling by 2 percent because of the need to balance their budgets, rather than rising 1 to 2 percent as would be expected in normal (non-recession) years.
• Federal government spending has been increasing by 6 to 7 percent in the past two years due to large stimulus measures. But unlike in many states, there is not a legislative mandate to balance the federal budget. The historical growth rate had been 1 percent above inflation.
• Real estate construction spending has not experienced any meaningful growth lately; the good news is that is has not been decreasing as during the recession.. Given higher than normal vacancy rates of both residential and commercial properties, recovery in real estate construction could be subpar for a while.
• Net exports were improving a bit -- with export growth outpacing import growth. But going forward, the need to import more oil and probably at higher prices will not lead to any meaningful improvement in net exports. Consequently, do not expect any help to GDP growth from foreign trade.
• After big cuts in business spending in 2009, private fixed investment (which encompasses purchases of equipment, plants, software and the like) has started to rise but remains well short in relation to the growth in corporate profits. Currently, profits have returned to their peak levels that were set in 2006. But business spending still remains 23 percent below its peak. Businesses are not spending as they should. This is a major obstacle to economic acceleration and better times. The uncertain and perhaps perceived unfriendly business environment resulting from many legislative/regulatory changes of the past year and additional expected changes to be imposed on them (from recently passed legislation) could be a key reason for business hesitancy. Still, perhaps businesses are just being extra cautious given expected slow spending patterns by consumers. Furthermore, trying to obtain small business loans is particularly difficult in the aftermath and fresh memory of a recent past financial market collapse.

One thing is clear, however: slow business spending will mean slow economic expansion and a slow pace of job creation. The frustration of traveling at 40 mph on a wide open 70 mph freeway will be with us for the foreseeable future if businesses continue to hold back. The unemployment rate could also remain stuck at a stubbornly high level -- 9.5 to 10 percent. It also means that home sales in the second half of this year will be markedly slower than in the first half of 2010.

For home sales, the only hope to restart any momentum in the absence of robust job growth is low mortgage rates. Thankfully, we still have that. The recent 4.5 percent rate on a 30-year fixed mortgage (for FHA and conforming loans only, not for jumbo or second-home purchases) is the lowest since April of 1971 at least (when Freddie Mac began tracking rates). To be honest, I did not expect to see rates this low and am pleasantly surprised. One reason for the low rates is due to some concerns about deflation in consumer prices. The Federal Reserve will be in no hurry to raise the short-term Federal Funds rate. Banks will not have to worry about losing purchasing power of the returned money, and hence, can lend at very low rates. Another reason for such low rates is that businesses have high profits and are not borrowing and spending. So despite a very high federal budget deficit and government borrowing, long-term interest rates have fallen to their lowest point since at least 1971 – and perhaps even earlier.

Despite the positive of low interest rates (which should encourage and abet borrowing), consumer prices could stop decelerating and start to move up. If that happens, watch out for what happens to interest rates. The latest overall consumer price index for June fell for a third straight month, partly due to falling energy prices. But the core consumer price index (minus the energy and food components) has been inching up in the past three months, though not to any alarming levels. The upcoming months’ consumer price indices will show a rise simply from the fact that oil prices have increased since June – perhaps in part due to seasonal factors; or concerns about the oil spill in the Gulf. In fact, one maverick voting member of the Federal Open Market Committee (FOMC -- the committee that decides on our nation’s monetary policy) has been warning of future eventual inflation in the U.S. Thomas Hoenig of the Kansas City Federal Reserve has been casting a dissenting vote on the direction of the nation’s monetary policy. Note: dissension among FOMC members is very rare. (And for future planning, Mr. Hoenig will be joining me to speak in November at NAR’s annual conference).

The outlook, therefore, for the economy and housing does remain unusually uncertain. But let’s keep in mind that even in the worst possible case, there will be some level of home sales. Remember that back in 1982 mortgage rates averaged 18 percent; there were 40 million fewer jobs back then compared to now. Even then, existing home sales still managed to reach over 2 million units and many REALTORS® survived through that unhappy experience. On the bright alternative scenario, if business spending comes back to where it should be, then GDP could easily grow at 5 percent rate. That would correspond to very healthy job gains of possibly 3 million in a single year. As we know, people with jobs, buy homes. That would, indeed, be a good sign for housing.

For the latest economic forecast insights and analysis, visit http://www.realtor.org/research/economists_outlook.