What happened to the housing cycle? It's different but not dead. By David F. Seiders

Housing typically has been the most volatile sector of the U.S. economy, leading the overall economy into recessions and losing an inordinate amount of ground during cyclical contractions. The United States fell into recession last March and the contraction deepened as 2001 rolled along, while housing had a very good year. But this does not mean that the cyclical mold has been broken.

New patterns?

In the past, housing production has been highly cyclical because housing normally is financed with long-term debt, and purchases of homes generally are highly discretionary. The typical leading role of housing has largely reflected the fact that most recurring downturns have been provoked by tightening of monetary policy by the Federal Reserve.

Recent data certainly suggest that this mold has been broken: The Fed eased monetary policy throughout 2001; housing market activity surged in the first quarter of 2001 and remained at quite a healthy pace throughout most of the year; the economy entered a recession in March 2001 and the downslide continued through year-end. Thus, this recession sure doesn't look like the Fed's work, and housing sure doesn't look like it led the economy into this recession.

But timing really is everything, and some backward glances are instructive. The Federal Reserve tightened policy substantially in late 1999 and the first half of 2000 and maintained a highly restrictive stance during the balance of 2000. The Fed's tightening process drove market interest rates upward, and the 30-year mortgage rate moved up to 8.65 percent by May 2000. The housing sector began to weaken, right on cue, and then economic growth started to deteriorate. A classic economic slowdown clearly was underway in 2000.

Complications arose

But some blockbuster developments occurred in the second half of that year, complicating the Fed's plan and messing up the normal sequence of events. These events included the stock market crash and turmoil in world energy markets. Then, as investors bailed out of the stock market, and it became clear to everybody that the U.S. economy was really slowing down, long-term rates fell like a rock before the Fed began to ease policy on Jan. 3, 2001. That fall in yields brought the 30-year mortgage rate close to 7 percent by the end of 2000, halting the Fed-induced weakening in housing market activity and giving housing an unprecedented second wind.

We'll never know if the recession of 2001 would have been averted in the absence of the terrorist attacks of Sept. 11, but it's clear that the Federal Reserve intended to engineer an economic slowdown that would run at least from mid-2000 until mid-2001. It's also clear that the fundamental linkages between monetary policy, housing, and the economy are still intact, even though abnormal events distorted the picture in both 2000 and 2001.

Looking ahead

The housing cycle isn't dead, but future housing cycles are likely to be less severe than in the past. Improvements to the housing finance system as well as conservative inventory management by builders (encouraged by construction lenders) have been making housing cycles shallower over time, and that trend is likely to continue.