May 20, 2009
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The Economic Contraction Is Losing Steam
The sharpest contraction in economic output (real GDP) during the current recession apparently occurred in the final quarter of last year when a massive financial market shock threatened to throw the U.S. and global economies into 1930s-like depressions. The “Great Recession” is hardly over, but the rate of decline is slowing and the light at the end of the tunnel is coming into view.

GDP contracted at an annual rate of 6.3% in the fourth quarter of 2008, quite a serious matter. The “advance” estimate for the first quarter of this year was down a dismal 6.1%, but late-breaking March data on construction, international trade and business inventories point toward an upward revision to the contraction to about 5.5% — close to our original projection.

Available information on economic activity and financial market performance suggests that the rate of contraction in real GDP will ease off considerably in the second quarter. We’re currently estimating a 1.2 % rate of contraction for this quarter, as the fiscal stimulus program adds about 2 percentage points to growth and as business fixed investment (residential and nonresidential) contracts at a slower pace than in the first quarter.

We continue to believe that GDP growth will swing into the black in the second half of this year, aided and abetted by the fiscal stimulus program and by the financial market policy blitz engineered by the Federal Reserve, Congress and the Administration. However, we’re expecting below-trend GDP growth that will be accompanied by further deterioration of the labor market.

That pattern may or may not be strong enough to encourage the Business Cycle Dating Committee at the National Bureau of Economic Research to declare an end to the recession before the end of this year.

The Labor Market Will Lag the Recovery in Economic Growth
The labor market has been taking it on the chin since last fall as businesses have unloaded tons of workers and clamped down hard on compensation rates. This has been a cruel but essential process that has helped restore business profitability, reduce unit labor costs and make inflation a non-issue for the foreseeable future.

Furthermore, improvements in labor market conditions typically lag upturns in economic growth by at least several quarters as an upswing in labor productivity (output per hour) supports output growth while persistent slack in labor markets keeps downward pressure on compensation rates.

The employment report for April was dismal, showing a loss of 539,000 payroll jobs, downward revisions to both February and March and a jump in the unemployment rate from 8.4% to 8.9%. The most comprehensive measure of under-employment, including discouraged workers and those working only part time for economic reasons, moved up to a lofty 15.8%.

Everything considered, the deterioration of the labor market was somewhat slower in April than during the previous five months, and initial claims for unemployment insurance have been “rolling over” recently following a dramatic upswing during earlier stages of the recession.

We expect the contraction of payroll employment to slow considerably in the second half before turning positive early next year. The unemployment rate is likely to rise to about 9.6% before showing some gradual improvement in the second half of 2010. [return to top]

Destructive Deflation Is Not in the Cards
The Federal Reserve, the guardian of the purchasing power of the currency, historically has identified price stability as a key target for monetary policy. However, recent Federal Open Market Committee statements have sounded a deflation alarm, citing the risk that inflation could drop “below rates that best foster economic growth and price stability in the longer run.”

The Fed clearly has been wary of a Japanese-style deflation process that would be difficult to shake.

Federal Reserve Chairman Ben Bernanke recently told members of Congress’ Joint Economic Committee that inflation is likely to move down over the next year, relative to its pace in 2008. However, he noted that stable inflation expectations, as measured by various household and business surveys, should limit further declines in inflation, that is, the deflation threat has receded in the context of an improving economy.

Recent top-line inflation measures actually have dipped into the red zone, primarily reflecting major declines in energy prices since mid-2008. However, key “core” inflation numbers, excluding food and direct energy prices, still are comfortably in the black and the recent behavior of commodity prices, including oil, will take downward pressure off the top-line measures before long.

Both the core Consumer Price Index and the core Producer Price Index have been registering year-over-year increases in the 1.8% to 1.9% range in recent months.

NAHB expects these measures to slow further over the balance of this year and in 2010, dipping below the Fed’s apparent comfort zones, but we do not view outright deflation as a serious threat. [return to top]

Financial Markets Are Healing Slowly
Bernanke has repeatedly said that economic recovery cannot develop unless major repairs are made to the financial system. On May 5, he told the Joint Economic Committee that conditions in a number of financial markets had shown some recent improvement but that financial markets and financial institutions “remain under considerable stress.”

He also noted that cumulative declines in asset prices (equities and homes), tight credit conditions and high levels of risk aversion “continue to weigh on the economy.”

The markets for short-term funding, particularly the interbank loan and commercial paper markets, clearly are functioning better than in late-2008 and early-2009.

Asset-backed securities (ABS) markets, particularly for credit card, auto and student loans, also have improved recently, presumably reflecting the availability of the Fed’s Term Asset-Backed Securities Loan Facility (TALF) as a market backstop. And the home mortgage markets have responded favorably to the Fed’s purchases of agency debt and mortgage-backed securities, and most credit now flows through Fannie Mae, Freddie Mac and the Ginnie Mae mortgage-backed securities program.

With respect to corporate financing, the broad rally in equity prices from the March lows, combined with significant reductions in risk spreads in corporate bond markets, presumably reflect a more optimistic view of the corporate sector in the investment community. Even so, spreads over comparable-maturity Treasury rates remain quite elevated and investors apparently still have substantial concerns about the banking industry.

These concerns have not been alleviated by reports from the Supervisory Capital Assessment Program that’s being applied to the 19 largest bank holding companies.

Everything considered, it’s fair to say that repairing the financial markets is underway but there’s a long way to go before most markets will be functioning normally. This reality will not prevent economic recovery, but it definitely will place limits on the early stages of growth. [return to top]

Measures of Housing Affordability Improve Dramatically
The affordability of home buying has improved dramatically over the past three years, and key measures recently have attained record highs — including NAHB’s quarterly Housing Opportunity Index and the National Association of Realtors® monthly Housing Affordability Index.

The improvements in key measures of affordability have been driven largely by stunning reductions in sales prices, particularly during the past year, and those reductions have partly reflected an upswing in foreclosure-related sales at fire-sale prices — a phenomenon that has put some downward price pressure on sales that have nothing to do with foreclosures or short sales.

Recent affordability improvements have also reflected substantial declines in rates on mortgages used to finance home purchases. In this regard, it’s noteworthy that virtually all purchase mortgage loans now are fixed-rate contracts, despite the strong upward slope to the Treasury yield curve. The “exotic” ARMs with low initial rates that pushed home buying to unsustainable levels during the boom now are a thing of the past.

Increases in standard affordability measures do not necessarily translate into home buying activity, of course, as these measures fail to capture changes in mortgage lending standards, house price expectations or the influence of the current and expected economic environment — factors that have tended to discourage home buying in recent times.

But some worms have been turning on these fronts, lessening the impediments to buying and helping to lay the groundwork for a broad-based recovery in home sales. [return to top]

Surveys of Consumers and Builders Signal Revival of Home Buyer Demand
The stunning improvements in major measures of housing affordability, along with temporary federal and state tax incentives for first-time buyers and new-home buyers, have served to stabilize housing demand and to encourage the beginnings of recovery. This revival has occurred despite the persistence of extremely weak economic conditions and serious tightening of lending standards in major components of the home mortgage market.

The University of Michigan’s survey of consumer sentiment showed that 79% of households had a favorable view of home buying conditions in the early part of May — up substantially from the cyclical low in early-2006 and the highest reading since early-2004. The revival primarily reflects the major price reductions that have accumulated since 2005, and historically low mortgage interest rates have also caught the fancy of consumers in recent months.

NAHB’s proprietary survey of large public and private single-family builders provides concrete evidence of recent stabilization and improvement in both gross home sales (new orders) and net sales (accounting for cancellations) — on a seasonally adjusted basis.

Gross sales hit bottom in February and registered significant improvement in both March and April. Net sales actually bottomed out late last year and have shown substantial improvement in recent months, particularly in April.

NAHB’s broad-based single-family Housing market Index (HMI) had been mired in a narrow record-low range from November of last year through March of this year. However, the HMI broke out of this range with a decisive move in April — from 9 to 14 — and registered further improvement when it rose to 16 in May.

While the HMI level still is quite low, the recent turnaround has been broad based, showing up in all major regions of the country and in all HMI components — present sales, expected sales and buyer traffic. [return to top]

Recent Housing Production Pattern Is a Mixed Bag
The overall level of housing production is quite depressed and the recent pattern is quite a mixed bag, with some components showing stabilization and even hints of improvement while others are displaying sharp retrenchment.

Single-family housing starts for April were up by about 3% from March and from the average for the first quarter of the year. Single-family permits show much the same pattern, and it’s possible that the low point for this dreadful cycle was reached in the first quarter — a bit earlier than in our most recent forecast.

In this regard, it’s reassuring that single-family starts for sale (excluding homes built on owners’ lots) now are down to about two-thirds of the total, compared with more than four-fifths during the unsustainable boom period and reasonably close to the long-term average share.

The multifamily housing sector held up relatively well through mid-2008, but this sector now is contracting rapidly. Multifamily starts were down to 172,000 units in the first quarter of this year (seasonally adjusted annual rate), nearly 50% below a year earlier, and starts crashed to a 90,000 rate in April.

The condo component of the multifamily sector is reeling, the subsidized rental component is essentially dormant, and the market-rate rental component is fundamentally weak — due partly to conversions of condo projects to rental projects in recent times. The for-sale share of multifamily starts was only 14% in the first quarter, down from about 50% at the height of the boom and below the long-term average.

The April multifamily starts numbers presumably reflected typical short-term volatility in this data series, and things may not be quite as bad as they look. However, permit issuance also was quite weak and it’s clear that the multifamily sector, in total, still is on a downward trend. [return to top]

Tight AD&C Credit Conditions Will Sap Strength of Recovery in Housing Production
Historically high inventories of vacant new and existing homes on the market will put downward pressure on house prices and exert a drag on the recovery of housing starts for some time, even as the recovery of housing demand gains some upward momentum. Indeed, those inventories will continue to be fed by a foreclosure wave that has not yet crested.

Weak housing market fundamental have not escaped the attention of depository institutions or their regulators. Consequently, conditions have continued to tighten in the markets for loans to acquire and develop land and to construct homes — the AD&C credit markets. Surveys by NAHB and the Federal Reserve document recent tightening and point toward further tightening down the line.

The Fed’s most recent Senior Loan Officer Opinion Survey on Bank Lending Practices, covering the first quarter of the year, revealed serious tightening of lending standards for commercial real estate lending , a category that includes residential construction and land development loans.

That survey marked the 14th consecutive quarter of credit tightening, showing that two-thirds of banks tightened in the first quarter while no banks eased their standards. Furthermore, 90% of bank loan officers expected the quality of existing loans to continue to decline over the balance of the year — hardly an encouraging signal for builders and developers seeking new loans.

NAHB’s first-quarter survey of builders regarding conditions in the AD&C credit markets showed extensions of patterns identified in a series of surveys conducted during the past two years, such as progressive tightening of lending terms and standards for prospective new loans as well as for outstanding credits.

Lenders told builders that the tightening process has largely reflected pressures from regulators and boards of directors and those pendulums are not likely to swing back in short order. [return to top]

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