THE 2004–2005 HOUSING BOOM TOOK HOME sales and housing production well above levels supportable by demographics and other fundamental demand factors—and we're now in the midst of an inevitable downswing. But there are limits to the housing adjustment, and the U.S. economy will not be pulled into recession as housing seeks a sustainable level of market activity.

LIMITS TO THE DOWNSWING It's clear that the housing downswing still has some distance to go, if only to work off excess supply in markets for both new and existing homes. Builders are doing their part on the supply side by cutting back on starts of new units, by trimming prices, and by offering sizeable nonprice sales incentives to limit cancellations and bolster sales. On the demand side, various economic and financial market fundamentals should support home purchases for the foreseeable future, helping to achieve the inventory correction. These fundamentals include the following:

  • Payroll employment growth is proceeding at a sustainable pace of about 120,000 per month;
  • Household income growth is strengthening as the economic expansion proceeds;
  • The interest rate structure is quite favorable, mortgage credit is readily available, and monetary policy now is stable; and
  • Energy prices have receded from record highs earlier this year.
  • HOW LOW WILL IT GO? As long as the economy remains in good shape, interest rates remain close to current levels, energy prices remain below recent highs, and sellers of new and existing homes adjust prices or offer incentives to meet current market realities, the rest of the housing market correction should be of limited depth and duration.

    It's likely that the bulk of the downswing in home sales and housing production will occur this year, with market activity stabilizing around mid-2007 and moving back up toward trend by late 2008. The NAHB's forecast has a cumulative shortfall of housing starts (below our estimate of sustainable trend) of roughly 400,000 units from the middle of this year through the end of 2008, in line with the estimated excess supply generated during the boom.

    HOUSING AND THE ECONOMY The U.S. economy can continue to grow at close to a trend pace even as the downswing in home sales and housing production runs its course. For one thing, the housing correction is a relatively isolated event, primarily reflecting recoil from earlier excesses within the sector—particularly the binge of home buying by the investor/speculator crowd. Furthermore, the housing downswing is occurring at the same time that other sectors of the economy are in midcycle expansion phases. This is true of business spending on capital equipment and software, non-residential structures, and exports.

    This type of sectoral rotation actually will give new life to the economic expansion—now nearly five years old—and the net outcome should be trend-like gross domestic product growth with manageable core inflation and reasonably stable interest rates in 2008 and beyond. That's an environment in which housing will be able to deliver healthy, trend-like performances of its own, riding on strong demographic trends and other fundamental demand factors.

    Chief Economist, NAHB Washington, D.C.

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