The most negative analysts on housing expect a downward spiral of house prices triggering major weakness in consumption spending and the overall economy. We expect a housing recession to generate only moderately below-trend GDP growth for several reasons. First, only a small fraction of total mortgage borrowers are financially vulnerable, despite a major rise in the risk profile of recent mortgage borrowers. Second, interest rates have moved higher, but are not that high in absolute terms. Third, the labor markets remain tight, which should support income growth. Fourth, weaker housing demand should be partially volume-adjusting through a fall in housing starts and completions as the profit margins of builders drop. This slowdown in new supply is likely to mitigate the magnitude of downward pressures on housing prices. Fifth, the lagged positive wealth effect of past house price increases should initially offset part of the negative impact of a nationwide stall in house prices. Some Wall Street economists argue that the slower "mortgage equity withdrawal" in prospect for the balance of this year will have a severe and immediate impact on consumer spending, especially in an environment of high gasoline prices. In contrast, some traditional econometricians argue that it is a slower process and the lagged impact of past wealth increases should not be ignored. Our view is that the sector has begun a housing recession that may not bottom until the last half of 2007 and that the negative effect of the housing weakness is likely to be more intense in 2007 than in 2006 as the lagged benefit of past wealth increases slowly wear off. Housing-related employment has stalled but major declines have been postponed by the shift of labor to non-residential construction and the need to complete residential projects under construction. A more substantial fall in housing-related employment is likely in 2007.
We believe that the odds of full-scale recession in 2007 are only about 15%. The yield curve is now slightly inverted. Some models using the yield curve as a key input are estimating a substantial risk of a recession in 2007. Chairman Bernanke expressed some hesitancy about putting too much weight on the yield curve as a reliable forecast indicator in his March 20, 2006 speech entitled "Reflections on the Yield Curve and Monetary Policy," and we agree with his analysis. In the past, inverted yield curves have preceded economic recessions and profit recessions. There are two reasons for this. One is that the marginal profitability of extending credit by banks and other financial intermediaries tends to dry up as the yield curve inverts. This effect has been muted in this expansion by the increased use of market-based financing which is not intermediated by the banks. A variety of credit risk spreads in the marketplace remain low, indicating continued availability of credit.
According to the Fed's own July 2006 Senior Loan Officer Survey, "... domestic and foreign institutions indicated that they had eased lending standards and terms on commercial and industrial (C&I) loans somewhat further. Domestic banks, however, reported that they had tightened lending standards on commercial real estate loans over the previous three months, while foreign banks noted that standards on such loans were unchanged...In the household sector, a small net fraction of domestic respondents indicated that they had eased credit standards on residential mortgages over the previous three months, while standards and terms on consumer loans were reportedly little changed. Significant net fractions of domestic institutions noted that demand for both mortgages to purchase homes and consumer loans had weakened further."
Our argument is that while we expect some cooling in the demand for credit in response to the uncertain housing outlook, the supply and availability of credit remains ample so far. We would be more reluctant to advance this argument if the yield curve were substantially inverted in an environment where risk spreads had widened in a major way. In such a case, the credit supply from both the banks and the markets would tend to be more restricted and the risks to the economy would be greater.
The second reason why inverted yield curves have been good forecasters of future recessions is that they embed the market expectations about future short-term rates. When the yield curve is significantly inverted, it reflects a market consensus that short-term rates will be lower in the future than they are today, presumably due to expected economic weakness. While we would regard a severely inverted yield curve as a valid signal of a major economic slowdown in the future, slight inversions of a few basis points are likely to be consistent with only a mild future deceleration in the growth rate of the economy. We expect that the U.S. yield curve will be slightly inverted over the course of 2006, anticipating a deceleration in economic growth in 2007.
Our view is that (1) the U.S. economy is in the cyclical phase of rising core inflation, (2) the core inflation cycle is occurring within a band of moderate inflation, (3) some of the inflation acceleration so far is attributable to portions of the indicators which may be over-representing the intensity of inflation risks, (4) the moderate but persistent upward pressure on core inflation will eventually ease, but only gradually, (5) the housing sector has entered a housing recession which should contribute to below-trend economic growth in 2007 and (6) there are good odds that the Fed is correct to forecast that past tightening will generate an economic slowdown but not a recession and will eventually lower the core inflation rate.
Disclosure: This comment represents the consensus at CrossProfit.com. Mellon Financial Corporation is not affiliated with CrossProfit. Written by Richard B. Hoey, chief economist and senior vice president of Mellon Financial Corporation, as well as chief economist and chief investment strategist of The Dreyfus Corporation.
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