by Calculated Risk on 12/21/2006 03:41:00 PM

Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond, spoke today on the economic outlook, with several comments on housing.

Since growth clearly has slowed, the question on many people's minds is, "What's next?"
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The distinguishing feature of the current transition is the magnitude of the adjustment in the housing market, which comes at the end of what has been an amazing, decade-long run. The homeownership rate increased by 4 full percentage points from 1995 to 2005, and the number of houses built per year increased by 46 percent over that 10-year period.
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The secular increase in housing demand in recent years was apparently satisfied in many markets by the end of 2005. Nationwide, new home sales have fallen by 22 percent through October of this year. The pipeline of new projects under construction was not scaled back as rapidly, however, and we now have excess inventories of new and existing homes in most localities. Production of new homes will have to undershoot demand for a time in order to work off the backlog. Indeed, new housing starts have fallen 28 percent through November of this year. The inventory overhang that remains suggests that homebuilding will be below demand for several more months.

This "several month" time frame seems very optimistic.

Looking ahead, there are tentative signs that the demand for housing has stabilized. New home sales have bumped around the 1 million unit annual rate for the last four months, and new purchase mortgage applications have risen over 15 percent in the last seven weeks. If these tentative signs are confirmed by more complete data then new home construction only needs to lag new home sales long enough to work off the current bulge in inventories. In this scenario, I would expect housing starts to realign with sales around the middle of 2007. Should new home demand deteriorate instead, the adjustment could take longer.

In any event, the weakness in housing will continue to be a drag on overall economic activity into the first half of next year, with the effect gradually waning as the year progresses. But I seriously doubt it will be enough of a drag to tip the economy into recession.
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Could weakness in the housing market spillover and weaken consumption spending as well? As residential investment contracts, construction employment will certainly decline. So far, residential construction employment has shed 110,000 jobs since the peak in February. At the same time, however, other segments of the economy have been doing well and overall payrolls actually expanded by 1.2 million jobs. This again reflects the small size of the residential construction sector relative to the overall economy. Although the outlook is for construction employment to continue to weaken for at least several more months, a decline commensurate with the fall-off we've already seen in housing starts still would have only a minor effect on total employment.

This is part of the reason the next 6 months are so important - as Lacker noted, residential construction "has shed 110,000 jobs since the peak in February". But there are 400K to 600K residential construction jobs that will probably be lost over the next 6 months.

It's not surprising that the economy could absorb the 110K jobs lost so far over a ten month period (about 11K jobs per month), but the rate of job losses is about to increase, and increase significantly. Will the economy be able to absorb that level of losses? That is a key question.

As I have said before, consumer spending is largely determined by current and expected future income prospects. I expect the overall job market to continue to expand even after accounting for further job losses in homebuilding, and I expect the tight labor market to continue to generate healthy wage gains. With income prospects looking good for 2007, it seems a pretty safe bet that consumer spending will do well, and again that's by far the largest part of the economy.

The consumer has been relying on personal income and borrowing against assets to sustain spending. With prices stable or declining for the most widely held asset (housing) in 2007, will consumers perceive their total income prospects as "looking good"? That is another key question.