Housing: a meaningful correction.

THE CORRECTION IN HOUSING activity has picked up momentum. This is evident in total home sales, weekly mortgage purchase applications, building permits, and construction activity, all of which are well below their peaks. Moreover, the National Association of Home Builders Housing Market Index

The downtrend in home sales should persist because affordability has fallen to its lowest level in more than a decade, severely strained by still-high home price inflation as well as higher mortgage rates. With inventories of unsold, new single-family units at record-high levels, new home price inflation is bound to decelerate faster in the months ahead. The adjustment in existing home prices, where appreciation has been extraordinary, should last longer. After all, existing home sales accounted for over 70% of the overall increase in home sales during the latest expansion. Despite outright price declines in some local markets, the national price indices seldom show yearly declines. Affordability is most strained on the West and East Coasts, where home price increases are still up 15-30%.

It helps that the broader economic backdrop remains favorable: solid job and income growth, a persisting relatively flat yield curve, and newly established immigrant populations becoming first-time homeowners. With Fed tightening nearly done, mortgage rates should ease, from about 6.80%--which is still low by historical standards--to about 6.25% by year-end and to 6.00% by late 2007.

Also, a big backlog of new homes that have been sold or authorized--but not yet started--should cushion somewhat the decline in residential construction activity. Nonetheless, housing starts are likely to continue falling through 2007, ending up about where they were in mid-2003.

Though unlikely to be as harsh as the 1987-91 downturn, the current housing correction should be meaningful (see chart), producing a powerful headwind for consumer spending. Hence, its direct and indirect impact should produce a drag on 2006-07 real GDP growth averaging about 1%, measured fourth quarter to fourth quarter. This would include some impact from a potentially diminished "wealth effect." This untapped home equity seems to have been more influential than tapped home equity in keeping growth in real consumer spending well above real income growth.

Interestingly, high levels of tapped home equity (mortgage equity withdrawal or MEW) seem to have been used to repay non-mortgage debt and to rebalance financial portfolios. Less than 40% of withdrawals has been used for home improvements and private consumption. Extracted mortgage equity has boosted growth in real consumer spending by only about 0.2%, which should erode as MEW declines.

The experience of the early 1990's suggests investment in home improvements will decline but not collapse, even if MEW dries up completely, which is not likely to occur.

NORA C. MIRSHAFII

Senior Economist,

United States Trust Company, N.A., New York