Vol. 4, Iss. 5, Associations: Inventory Overhang Heavy

by Chicago Agent

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

Growth of U.S. economic output (real gross domestic product) has slowed from the above-trend rates recorded earlier in the expansion, although overall GDP growth has held up reasonably well in recent quarters even as the housing production component (residential fixed investment) has contracted substantially.

Furthermore, the contraction in housing market activity and the slowdown in house price appreciation have not generated serious “spillover” effects in other sectors of the economy (including personal consumption expenditures), and strengthening activity in some sectors (including nonresidential construction) has helped offset the negatives from housing production.

As a result, the economy did not skate close to recession in 2006, and the probability of an economic downturn is not high during the 2007-2008 period.

Economic resilience also is evident in the labor market. The housing downswing caused job losses in residential construction during most of 2006 and into January, and further losses in construction are inevitable during coming months.

However, overall job growth was reasonably well maintained in 2006, and we’re expecting a solid performance in 2007 as well. The unemployment rate ticked up in January to 4.6 percent and is likely to gravitate upward somewhat further. However, we do not expect the unemployment rate to rise above 5 percent during the 2007-2008 period.

Core inflation receding
Key measures of core consumer price inflation (excluding prices of food and energy) firmed up during much of 2006, moving well above the upper bounds of the Federal Reserve’s apparent “tolerance zones.”

This inflation pattern naturally raised concerns at our central bank about potential economic “overheating” and prompted many financial market participants to anticipate some tightening of monetary policy in the near term.

As 2006 drew to a close, core inflation rates began to recede, at least on a year-over-year basis. The core Consumer Price Index slowed systematically during the fourth quarter, receding to a pace only slightly above the upper bound of the Fed’s apparent tolerance zone for this measure. Even more important, the core price index for Personal Consumption Expenditures — the Fed’s favorite inflation gauge — displayed the same type of pattern.

The evolving slowdown in core inflation had been projected by the Federal Reserve, and this pattern is an integral part of NAHB’s forecast for 2007 and 2008. The recent and projected improvements on the inflation front reflect modest slowdowns in growth of real GDP and employment as well as dissipation of some special factors that elevated core inflation last year.

On the latter point, the “owners’ equivalent rent” component of the core price measures has slowed to some degree and figures to contribute to the projected slowdown in core inflation in 2007-2008.

The Fed Is Anchoring the Interest Rate Structure
The Federal Reserve held monetary policy steady at the Jan. 30-31 meeting of the Federal Open Market Committee (FOMC). Indeed, the Fed has held its target for the federal funds rate at 5.25 percent since mid-2006, a level that’s around a “neutral” monetary policy stance in the prevailing inflation environment.

We expect the Fed to maintain this funds rate target until the late-June FOMC meeting, and we still anticipate a quarter-point rate cut at that time, in order to keep the “real” funds rate from rising as core inflation recedes.

Long-term interest rates firmed up to some degree in late-January and early-February as incoming data on the economy were surprisingly strong, but long rates have receded more recently. The long-term home mortgage rate is hanging around 6.25 percent, the same as a year earlier and one-half percentage point below the mid-2006 level.

The Treasury yield curve still is inverted across much of its range, a pattern that may not be sustainable for much longer. NAHB’s forecast shows an essentially flat Treasury yield curve by late this year, at least out to the 10-year mark, as short rates recede a bit and long rates move up modestly from current levels.

In this regard, we do not expect the long-term mortgage rate to move above 6.5 percent this year.

Heavy inventory overhang
Stabilization of housing demand (net sales) is the essential first step toward completion of the dramatic housing “correction” that has followed the unsustainable housing boom of 2004-2005.

The second step is to work down an excessive inventory overhang in markets for both new and existing housing, and the final step is to bring housing starts and residential construction activity back up to sustainable trend levels.

The inventory overhang in the markets for new and existing single-family homes came down a bit in the final months of 2006, at least according to the standard measures. However, inclusion of homes left with builders through sales cancellations, along with consideration of an elevated level of vacant for-sale homes in the existing housing stock, show that the inventory overhang is heavier than it appears at first glance.

The current overhang of vacant homes for sale (new plus existing) may not be the end of that story. The single-family rental vacancy rate recently climbed to a record level, presumably reflecting difficulties being encountered by investors that are biding their time before putting single-family homes back on the market.

It’s hard to estimate the numbers of single-family rental units that will become for-sale units, or the time frames involved, but builders should listen for this shoe to drop. There’s also the issue of competition from the multifamily condo market, where the number of vacant for-sale units (new and existing) has climbed even more dramatically (in percentage terms) than in the single-family market.

NAHB Chief Economist David Seiders analyzes the economy from the point-of-view of the housing market every other week in the free e-newsletter, “Eye on the Economy.”

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