Remarks by Jeffrey M. Lacker

It's important to remember that the recent housing market boom was driven by fundamental factors that were -- and still are -- quite favorable. I'll just briefly list a few for you. Population continues to expand; for example, last year the number of households increased by 1 percent nationwide. Income is growing -- so far this year, inflation-adjusted disposable income per person has increased at a 2.8 percent annual rate. We are a wealthy nation; household net worth is 53 trillion dollars, which represents over five-and-a-half years of disposable personal income. The tax treatment of housing remains highly favorable. Finally, mortgage interest rates were extremely low for many years, and even now are quite reasonable by historical standards.

Given these solid fundamentals, it is not surprising that the demand for housing has risen so strongly in recent years. As one would expect, we saw both higher production and higher prices in response to the sustained rise in demand. The rise in mortgage interest rates since 2004 has helped dampen the demand for housing, but it seems likely that much of the increase in rates was anticipated. In fact, the upward move in rates may have given an extra boost to demand in 2005 as consumers took advantage of the waning days of lower mortgage rates. With the surge in demand apparently satisfied now, we can expect to see a "return to normalcy" in the housing market, if I can borrow a phrase from a former Washington resident. Such a return to normalcy would involve lower production than we saw at the peak, and certainly a lower trajectory for housing prices.

This transition in the housing market is well under way. New home sales are down 17 percent, housing starts have fallen 20 percent, and the rate of price appreciation has fallen substantially, to the point that average prices were slightly lower in August than they were a year ago. These are national figures, of course, and more dramatic swings can be seen in some localities, particularly in areas that saw the strongest increases in housing prices and activity. The Washington area is a good case in point. Prices shot up more rapidly than elsewhere because strong area job growth created demand for housing that area builders had difficulty meeting. Builders say that the availability of building lots limited housing production in many localities within the region. And this makes sense as a simple matter of supply and demand: if supply does not expand elastically to meet a rise in demand, then prices have to rise instead. Indeed, looking across regions both within our District and around the U.S., home price appreciation was greatest where the supply of buildable lots seems to have been least elastic. One would expect most of the price increases in such regions to show up as rising land values, rather than as increases in the value of structures. And when demand subsides, land values reverse course. In contrast, prices did not accelerate as much during the boom in other metro areas in the Fifth District, where the supply of buildable lots was more elastic. And as a result, prices are not decelerating by as much in those areas either. Looking ahead, forecasts by area economists suggest that the Washington metropolitan area will continue to experience relatively rapid job growth. If correct, and if the supply of building lots remains inelastic, these forecasts suggest that the ongoing correction in area housing markets will find a floor sooner rather than later.

At the national level, some further retrenchment in housing markets is likely in the months ahead. But while there is substantial uncertainty about where the bottoming out will occur, I don't think a catastrophic collapse in housing activity is likely, since the fundamental determinants of housing demand that I listed earlier remain favorable: prospects for population and real income growth look good, net worth remains high, and after-tax mortgage interest rates are still historically low. Instead, I believe we are seeing a return to a more conventional level of housing market activity in which volume, inventories and time-on-market are closer to historical averages. This adjustment naturally involves a fair amount of uncertainty for market participants. Both buyers and sellers are probably more unsure than usual right now about where prices need to settle in order to clear markets. In the meantime, they are collectively engaged in a time-consuming process of discovering the prices at which expectations and plans of buyers and sellers are mutually consistent.

Many macroeconomic analysts are concerned about the potential fallout of a weakening housing market. The direct impact of the housing market on overall economic activity is easy to calculate. The measure of residential investment spending that is included in real GDP has now fallen for three consecutive quarters. In the second quarter it fell at an annual rate of 11.1 percent, and appears likely to decline even more rapidly in the second half of this year. Since residential investment accounts for less than 6 percent of GDP, that lowered the real GDP growth rate by about seven-tenths of 1 percent in the second quarter. It would not be surprising to see housing reduce growth by even more for a few quarters. That would be a significant drag on the economy, but it would not end the expansion either, especially in light of offsetting strength in business investment spending, a topic I will touch on later.

While the direct effect of housing on GDP may not be overly large, some analysts worry about indirect effects, such as lower housing wealth leading to lower consumer spending. Again, it's important to begin with fundamentals. While fluctuations in household wealth are capable of affecting spending at the margin, the behavior of consumers is predominantly determined by their current and future income prospects. And those prospects are looking pretty good right now. With the unemployment rate below 5 percent, the labor market is looking fairly tight right now. Despite large increases in gasoline prices earlier this year, inflation-adjusted incomes are rising, as I noted earlier. And now that we've seen some relief at the gas pump, it would not be surprising to see a modest pickup in real income growth in the next couple of months.

The deceleration and fall in housing prices certainly will cut in to household net worth to some extent, but so far, such wealth effects have done little to slow household spending.

Could housing prices end up falling sharply enough to cause consumers to rein in spending? Perhaps, but consumers' balance sheets generally are not as fragile as some commentary might lead one to believe. Housing debt is only 44 percent of the value of household real estate. With that substantial equity position, most homeowners who are not planning to move for other reasons can pretty much ignore transient price fluctuations. And with relatively high levels of financial net worth, most households are well buffered against price fluctuations. Moreover, as I emphasized earlier, household spending is driven mainly by current and future income prospects. Taking all these considerations into account, I would look for consumer spending to continue to expand at a reasonably good pace, even if housing prices come in weaker than I expect.

I should note that the end of the housing boom could not have been a complete surprise to most participants. Sure, it's nice to sell your home when bidding wars and escalator clauses are common, as they were in 2005. But these conditions were fairly unusual in most markets, and it's hard to believe many people seriously thought they would persist indefinitely. This is another reason to believe that most people are likely to be reasonably well-positioned for the end of the boom.

Another potential spillover that some analysts like to mention involves mortgage lending, especially with new financing options available to consumers. My sense is that the underwriting and pricing of mortgages has on the whole been sound, despite some individual anecdotes that suggest otherwise. The broad range of households that have taken out nontraditional mortgages are going to find them advantageous, even if, as with many financial products, a small fraction end up regretting their choice after the fact. Moreover, the banking industry looks healthy right now, with strong profitability and high levels of capital. Loan delinquencies are quite low by historical standards, as are chargeoffs of real estate loans. So it looks to me as if the end of the housing boom is unlikely to have any broader spillovers as a result of financial repercussions. Nor is it likely to be exacerbated by financial disintermediation of the type we saw earlier in the postwar era.

The labor market is another potential arena for adverse spillover effects from the housing market. We have seen employment in the residential construction sector fall this year as residential building activity has declined. Fortunately, however, nonresidential construction is on an upswing -- over the four quarters ending in June, real nonresidential investment rose 7.2 percent. Further increases in nonresidential construction will allow many workers to simply change construction jobs rather than become unemployed. Indeed, over the last year overall construction employment has actually risen by nearly 210,000 jobs even as housing activity has softened.

As I mentioned earlier, the expected further weakening in housing activity is likely to be largely offset by business capital spending. Over the last three years, business fixed investment has grown at a quite solid 6.6 percent annual rate. Since business fixed investment is over 10 percent of GDP, this means that is has added about two-thirds of a percentage point to GDP growth, which has counteracted the drag from housing that I cited earlier. Indeed, when business investment demand fell sharply following the technology boom of the late 1990s, and the FOMC lowered interest rates in response, the anticipation was that interest rate-sensitive sectors such as housing and consumer durables would take up some of the slack until business investment spending rebounded. Now that business investment has substantially recovered, it makes sense for housing activity to subside in turn.

The fundamental underpinnings of near term investment demand are encouraging. Profitability is high, capacity utilization has been steadily rising, and many firms see strong demand for their products. Thus, it is not surprising that new orders for capital equipment increased 7.5 percent over the last year, and I see a solid outlook for capital spending over the next several quarters.

So, the outlook for overall spending looks reasonably good -- consumer spending is on track, business investment is robust, and the softening in the housing market is not likely to be large enough to cancel out those sources of strength. To round out the picture on the national economy, let me say a few words about the labor market and the inflation outlook. Last year we added almost 2 million jobs, or about 165,000 jobs per month. We maintained that rapid expansion in the first quarter of 2006, but over the last six months job creation has averaged 118,000 jobs per month. While that sounds low, it's actually pretty close to what we would need to keep employment growth in line with population growth. And with the unemployment rate fairly low, it's appropriate that employment growth is close to its trend value. So what we're seeing in the labor market looks quite consistent with trend growth in overall economic activity.

The inflation outlook, on the other hand, is less appealing, and that is quite important to us at the Federal Reserve because as I mentioned earlier price stability is our central responsibility. I've said on several occasions that I would like to see inflation average about 1.5 percent over time, as measured by our preferred statistic, the price index for core personal consumption expenditures (often referred to as just "the core PCE index.") Moreover, I have also said that I would be comfortable if inflation was a little higher or lower, coming in between 1 percent and 2 percent. Several other policymakers and economists have also endorsed that range as a functional definition of price stability. But inflation has been outside that comfort zone for over two years now. It was 2.2 percent in 2004, 2.1 percent in 2005, and has come in at a 2.5 percent annual rate so far this year. And inflation looks worse if, instead of using the core PCE index, we were to use the overall index, which includes energy prices. That measure of inflation was 3.2 percent over the last 12 months.

My concern regarding these inflation readings is straightforward. On a month-to-month basis, practically anything that affects the supply or demand for particular commodities can unexpectedly move a price index around, and the financial press dutifully highlights a different special factor each month. But over a period of several years, a central bank can achieve whatever average inflation rate it chooses. And while there really is no benefit to high inflation, keeping inflation low and stable has a wide range of benefits to society. Low inflation helps people make better plans and commitments, since they will have a better idea about the future purchasing power of their money. And when inflation is low, people don't have to devote time and effort to protecting their wealth from being eroded by inflation. Thus, it is quite important to keep inflation from drifting away from target over time.

Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC's reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don't have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability.

Source: Federal Reserve Bank of Richmond