EconSouth - Fourth Quarter 2007

A Look Ahead: Housing, Energy Squeezed in '08

If the United States experiences subdued economic growth in 2008, it will primarily be because of factors already at work: a slumping housing market, high energy costs, and turbulence in financial markets.

Housing & Energy Squeezed

In 2008 the U.S. economy will face several challenges, including risks that have affected the economy for nearly two years. With the continuing contraction in housing market activity, higher energy prices, and generally tighter lending standards by banks, the outlook centers on the extent to which consumer and business spending will weaken. Many forecasters expect that the U.S. economy will experience subdued economic growth in 2008, somewhere in the range of 2 to 2.5 percent as measured by real gross domestic product (GDP). This forecast is a notable step down from the growth observed on average in 2006 and 2007 and carries with it considerable downside risks.

To put this forecast into perspective, the post-2001 economic recovery and expansion highlight both the unevenness and the underlying resilience of the U.S. economy. In 2002 the economy was still struggling with the aftermath of the dot-com investment boom and bust. Then, in 2003, the Iraq War began, and oil prices increased. Energy price volatility was exacerbated in 2005 when Hurricanes Katrina and Rita pummeled the Gulf Coast and took a substantial amount of the nation's energy infrastructure temporarily off-line. By 2006 the U.S. housing market began to contract; that contraction became more pronounced in 2007 and is expected to continue in 2008.

Housing market in the doldrums
Almost every national housing statistic reflects weakness. For instance, in October the sales of new single-family homes had dropped 24 percent year over year and building permits had plunged 31 percent, according to U.S. Census Bureau data (see chart 1).

The contraction in the nation's housing industry has greatly distressed Wall Street financiers and Congress as well as consumers and nonfinancial businesses. Nearly six consecutive quarters of substantial contraction in residential investment are taking an obvious toll on some parts of the U.S. economy. Businesses with direct ties to housing, such as construction firms, building material suppliers, real estate and mortgage brokers, and landscapers, are all feeling the brunt of the housing downturn.

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Most forecasters do not anticipate any stabilization in national housing market conditions until at least the second half of 2008. However, the depth and length of the downturn also remain quite uncertain and will depend on several variables. These variables include the number of foreclosures that will add to the supply of homes on the market, the extent to which mortgage market borrowing is impeded for consumer borrowers, and the amount by which home prices decline.

The most recent housing boom, which began after the end of the 2001 recession, was unusual by historical standards. Measures such as new home sales and new housing starts soared from 2002 through 2005. The home ownership rate, which had hovered around 64 percent for decades, spiked to nearly 70 percent as households that had previously been unable to finance a home purchase were offered mortgage financing through nontraditional mortgage vehicles, such as subprime mortgages. While these types of innovative mortgage finance instruments offered new possibilities for some buyers, they also posed some significant risks.

During 2004 and 2005, subprime mortgages were often prepaid as homeowners refinanced their mortgages when their home values appreciated enough to qualify them for a prime mortgage. But in 2006, as house price appreciation moderated and then flattened, refinancing homes purchased with subprime mortgages became more difficult.

Homebuyers with subprime adjustable-rate mortgages often had initial interest rates that reset to a higher level after some predetermined period of time. Without the refinancing option, these homebuyers have faced the prospect of substantially higher mortgage payments. As a result, delinquency rates on subprime adjustable-rate mortgages have increased during 2007, and the prices of structured financial products such as collateralized debt obligations that contained repackaged subprime mortgages declined notably. This decline brought about a contraction in subprime mortgage financing available for consumer borrowers. Other nonconforming mortgage financing, such as prime jumbo mortgages, has also been caught up in the financial market turbulence arising from the subprime mortgage problems. In fact, the volatility of the financial markets has added uncertainty to the economic outlook and has added risks to near-term economic growth.

Chart 1
U.S. Single-Family New Home Sales and Building Permits Issued
Chart 1
Source: U.S. Census Bureau

Chart 2
U.S. Real Personal Consumption Expenditure
Chart 2
Source: U.S. Bureau of Economic Analysis

Risks looming in 2008
Consumer spending. The prospect for consumer spending in 2008 is one of the risks for the overall economic outlook. The combination of declines in real estate values, reduced or more expensive access to real estate financing, and higher oil prices are all likely to dampen the pace of consumer spending (see chart 2). Subdued auto sales during 2007 are one indicator of this moderation. In addition, despite respectable post-Thanksgiving sales, many retail businesses are bracing for what they anticipate to be a relatively disappointing holiday shopping season. However, estimates of the effects on consumer spending are imprecise, and U.S. consumers have proved to be surprisingly resilient in the past. So far, it is reasonable to expect that consumer spending will continue to grow but at a more moderate pace than in 2007.

Business investment. Spending on business investments is another important component of the economic outlook. Business investment spending in 2007 was relatively strong overall. Despite some tightening in credit standards in the second half of the year, credit availability remained good generally. Anecdotal evidence obtained from various business contacts, though, indicates that heightened economic and financial uncertainty may restrain investment outlays in some industries and may thus restrain overall growth of business investment outlays in 2008. One specific downside risk to the business investment outlook is its potential dampening influence on already depressed nonresidential building activity, such as the development of suburban retail space.

Labor markets. The expected slower pace of economic activity in 2008 will also translate into moderately weaker labor market conditions. As a consequence, the unemployment rate is likely to increase in 2008. However, the increase in the unemployment rate could be muted if the weaker demand for labor is partly mitigated by continued slowing in labor supply growth associated with ongoing U.S. demographic changes, such as baby boomers retiring or further restrictions on immigration.

Exports, the dollar, and inflation. The growth of U.S. exports was one of the few consistent bright spots in the national economy in 2007. Depreciation of the dollar has improved U.S. exports' international competitiveness, and global demand for U.S. goods and services has been robust. Data suggest that economic growth outside the United States is likely to remain firm even though it is likely to slow somewhat in coming quarters. Relatively strong economic growth worldwide and the recent decline in the foreign exchange value of the dollar should continue to support U.S. exports.

While the dollar's lower foreign exchange value has been a boon for U.S. exporters, it also raises some concerns for the near-term inflation outlook. The dollar's decline, along with increases in the prices of energy and other commodities, could push up prices of some core (excluding food and energy) goods and services in the short term. The pass-through of higher import costs to consumers, however, is likely to be mitigated somewhat by competitive pressures that limit firms' ability to fully pass on their input cost increases. In addition, most indicators point to a moderation in oil prices in 2008, and this outcome would alleviate some inflationary pressures.

Many forecasters expect that annual headline inflation (as measured by the price deflator for personal consumer expenditures) will average around 2 percent in 2008. Indicators of longer-term inflation expectations, such as readings from Treasury Inflation-Protected Securities (TIPS), suggest that inflation expectations have not drifted outside recent historical norms. That said, the prices of oil and other commodities continue to be a major source of uncertainty for the overall inflation outlook.

Current risks may beset a new year
The pace of economic growth is likely to be slower in 2008 than it was in 2007. Inflation should moderate some over the coming year, but the recent run-up in oil prices could put upward pressure on inflation in the near term.

The most glaring fundamental weakness in the economy will continue to be the housing industry and associated businesses. The bottom of the housing downturn may not be reached until the second half of 2008 or even later. Several factors make the current economic outlook uncertain, and most of these risks emanate from the connections between the housing sector and financial markets. Currently, this spillover is expected to be limited to generally smaller increases in consumer and business spending than experienced in 2007.

Despite such challenging prospects, the fundamentals of the U.S. economy remain essentially sound, and, historically, the nation's economy has proved quite resilient to episodes of financial distress. Nevertheless, policymakers, consumers, and businesses will closely monitor economic activity in 2008 as the economy slogs through the painful housing industry adjustment, the challenges of loan defaults, foreclosures and the resulting dislocations, and the financial market responses to such events.

This article was written by John Robertson and Ellis Tallman, vice presidents in the Atlanta Fed's research department.