Richmond Fed's Lacker: No Fundamental Worries about Housing

Richmond Fed president Jeffrey Lacker gave a speech today and his outlook for both growth and inflation are optimistic. For output, he says:

It looks like we’re on track for continued expansion, with real GDP growing at about a 3 ½ percent annual rate this year. Consumer spending should grow in line with GDP and will be supported by job growth and real wage gains. Residential investment will flatten or slow, but business capital spending should remain robust. And that capital spending will support productivity growth going forward, which in turn will support the future income growth that keeps household spending healthy. And while there are risks to this forecast, as there are with any forecast, I do not see any single scenario that is compelling enough to alter the central tendency of this outlook.

And for inflation:

Let’s turn now to the inflation picture, where again things are looking better now than many had expected six months ago. ... longer-term expectations of inflation have remained moderate even as energy prices have moved up over the last couple of years. Looking ahead, short-term movements in the inflation rate can be hard to predict. But what is important is to stabilize inflation over medium- and longer-term horizons. And here the indicators about what the public expects look fairly good. Both survey data and the market prices of inflation-protected Treasury securities tell us that the public expects inflation to continue to be contained. ...

As for housing, he is not worried at all about the housing bubble popping because he doesn't believe there is a bubble. It's all fundamentals:

Looking ahead, to assess the outlook for consumers’ spending, you begin with their income prospects. Expectations are that the overall labor market will continue to be strong ... and further real wage gains should lead to healthy advances in incomes and, thus, overall consumer spending.

Before turning away from households, I’d like to touch on residential housing activity. As I’m sure you know, the housing market has had an amazing run in recent years. ... You won’t hear me use the B-word to describe this remarkable activity. Instead, I believe fundamental factors can fully explain the expansion we’ve seen in the demand for housing, particularly rising incomes, rising population, favorable tax treatment, and very low interest rates. At the present time, mortgage interest rates are not as favorable as they were a few years ago, and so it is not surprising that we are seeing some signs of a tapering off of residential activity in many markets. ... I see this not as a precipitous decline, but rather as a return to more normal conditions in many markets. ... Looking ahead, it seems reasonable to expect the housing market to remain strong, even as some further tapering off in sales and production takes place.

The key point I would like to emphasize is that the housing phenomenon was not a mysterious, independent boost to the economy, driven by some sort of animal spirits, but instead was a rational response by households to the economic fundamentals, especially very low real interest rates. Thus, going forward, the adjustment of the housing market ... will continue to fit comfortably within the standard economic framework. My assessment is that plausible rates of moderation in housing activity will not pose a problem for overall activity this year or next. Moreover, I don’t see diminished housing price appreciation as a major problem for consumer spending, since again, the primary determinant of spending is income, and we see solid and improving prospects for real incomes for the nation as a whole.

Update: Bloomberg report.

Update: From Calculated Risk:

DCalculated Risk: Dr. Leamer says: Expect Slow, Gradual, Painful House Price Declines: In this Mercury News article, UCLA's Dr. Leamer makes some interesting comments:

If history is any guide ... home prices won't peak for a while... When the end of the Cold War caused consolidation of the defense industry, the number of home sales in the Los Angeles area peaked in November 1988 -- but home prices didn't top out for nearly 2 1/2 years. "Then the prices began this gradual, painful, slow deterioration" of about 5 percent a year, Leamer said. "Don't watch the prices," he said. "Watch the volume."

In Santa Clara County, sales of new and existing houses and condos dropped 14 percent from the record mark set the previous February. It was the slowest February since 2001... If sales have peaked, Leamer predicts homeowners are likely to endure a test of their patience and financial mettle.

"It's really slow, not enough to drive you totally crazy," Leamer said. "It's a little bit of pain every year. If you try to sell, you can't find anybody to buy, and the price is eating into your equity little by little. That's the kind of adjustment we expect to see."

Update: William Polley covers a speech by Dalls Fed president Fisher. Fisher repeats a common theme in his recent speeches about the difficulties of measuring productive capacity and labor tightness in the presence of globalization.

Comments

[anne]

http://www.nytimes.com/2006/04/01/business/01bubble.html?ex=1301547600&en=cfe88a42340e601c&ei=5090&partner=rssuserland&emc=rss

April 1, 2006

Some New Math on Homes
By DAMON DARLIN

Gary and Margaret Hwang Smith spend a lot of time musing about real estate.

It is not just that the couple, economics professors at Pomona College, have put so much of their money in the game, having bought a home in Claremont, a college town in Southern California, a real estate market that has been described as overpriced by most and a bubble by some.

Rather, they said, applying economic tools to buy a five-bedroom 1922 Craftsman home sharpened their thinking and guided two years of research into whether there is a bubble. They concluded that not only was the Los Angeles region not in a bubble, but many markets that others were calling overpriced, like Chicago or Boston, were probably underpriced.

Their findings are at odds with other surveys that use the relationship of home prices to income to determine whether home buyers are overreaching. Homes in Orange County, Calif., were fairly priced, the Smiths found. Some cities like Dallas, Indianapolis and Atlanta were screaming bargains. Homes they surveyed in San Mateo County, south of San Francisco, were, however, overpriced by about 54 percent.

In a paper the two presented at the Brookings Institution this week, "Bubble, Bubble, Where's the Housing Bubble?" they said that even though prices had risen rapidly and some buyers unrealistically expected the trend to continue, "the bubble is not, in fact, a bubble in most of these areas."

They argued that the value of a home is determined by the rent it could fetch. Calculate the future rents, subtract mortgage payments, taxes and other costs, factor in a good annual rate of return of 6 percent or more, and one should be looking at the proper price of a house or condo.

Their bottom line was: "Buying a house at current market prices still appears to be an attractive long-term investment."

Speculating about bubbles — their cause, their longevity, and indeed, their very existence — occurs whenever there is a rapid rise in asset prices. When dot-com stocks pushed the stock market to record highs in the late 1990's, many people tried to explain — or justify — the high prices of the stocks by talking about how the Internet was creating a new economy, one that worked by different rules or needed valuations that did not depend on earnings but on eyeballs viewing Web sites or the "stickiness" of those eyeballs. Those justifications were proved false by the technology meltdown.

With real estate, there have been fewer attempts to justify the high prices and more of an effort to understand why it is happening and whether there is an asset bubble.

Robert J. Shiller, the Yale University professor who warned of the stock market bubble, has few doubts that a real estate bubble exists in many American cities....

[Winslow R.]

"Moreover, I don’t see diminished housing price appreciation as a major problem for consumer spending, since again, the primary determinant of spending is income, and we see solid and improving prospects for real incomes for the nation as a whole."

He stole my line though I would have added
'this benign outlook is predicated upon a currency adjustment and/or national minimum wage increase.'

[billy]

Oh really?

Many who bought on option and neg. am. loans are will not be amenable to this "Moreover, I don’t see diminished housing price appreciation as a major problem for consumer spending, since again, the primary determinant of spending is income, and we see solid and improving prospects for real incomes for the nation as a whole" line of thinking.

Thats what makes the whole game continue, faster appreciation than the negative cash flow, which makes a net positive gain.

And a large part of California is in this game.

Price is determined at the margins, and it is going to fall as a result. Economic laws dont stop working on orders from the Fed.

[calmo]

My view is that when it comes to housing, the Fed takes great pains to discount its importance. The antithesis of 'the high powered rifle', --the man may have been armed, but it was only a toy replica.

I don’t see diminished housing price appreciation as a major problem for consumer spending, since again, the primary determinant of spending is income, and we see solid and improving prospects for real incomes for the nation as a whole

Where? Real disposable incomes? As a whole, like as across the board from the minimum wage to Goldman's traders? [Mercedes posted a 20% sales gain last month, but GM took a 12% hit, no?]

I don’t see diminished housing price appreciation as a major problem for consumer spending, since again, the primary determinant of spending is income, and we see solid and improving prospects for real incomes for the nation as a whole

This banker is at pains to give the impression that we do not have a negative savings rate. We do. And Lacker knows this as surely as he knows his next birthday.
That primary determinant of spending has been supplemented generously by MEWs lately. Equity withdrawal depends on rising, not cooling, housing appraisals and declining refi rates, both of which Lacker knows are not happening.

Capital spending by companies this year will be ``quite robust,'' helping increase productivity, wages and household spending, Lacker said. Such business investment ``should be enough to support overall demand in the economy, even as the housing market cools down,
In fact record M&A was 50% above last year's --that's where companies spent their record earnings. The "support" that this business investment adds to the demand, could only be coming from the beneficiaries of the mergers: not the downsized labor pools, but the executives and their larger compensations.

I am not happy with Lasker and his efforts to placate those who are concerned about the housing market. The only driver in the economy for the past 6 years cannot have made any other impression on every member of the FOMC.
It is fading now and they know it.
"Don't worry" may be good advice from a mother to her child, but it is counter productive to those of us who aren't children.

[spencer]

Anne- the new study assumes price appreciation (6%) higher then the interest rate and this generates the results. But the reason for a 6% assumption is not
discussed in the study. GIGO.

[anne]

Agreed :) I am bothered by estimates of futre returns on American real estate in general. The Vanguard real estate investment trust index has an earnings growth rate of a negative -4.8%; indeed, the earnings growth rate has been negative for about 5 years. The price earning ratio for the REIT index is about 37. These valuations can make me awfully nervous even though I know all the rationales.

[knzn]

I think Calmo has hit the nail on the head, though he seems suspicious of Lacker’s motives, whereas I am just puzzled by Lacker’s willingness to ignore the elephant in the room. Income growth will have to be faster than what Lacker estimates in order to support a return of the savings rate to anything reasonable while at the same time allowing consumer spending to have “healthy advances.” The only way Lacker’s numbers would seem to add up is if he expects the savings rate to remain near zero. Perhaps he does. But if so, how does he explain the low savings rate? Are people so excited by the prospect of 3.5% growth that they are borrowing against future income? Maybe, but I think equity extraction is a more plausible explanation. And I doubt that flattening housing prices and rising interest rates will support much more equity extraction. If Lacker has other ideas, I’m willing to listen, but I wish he would be clearer about how his scenario holds together. It’s not very enlightening to talk about growth rates while ignoring the national income identity.

[anne]

The value of the dollar does not worry me, the trade deficit does not worry me, and I wish we were saving and investing more domestically but I am adjusted to this, what I have not been able to figure out however is what might take the place of housing in generating growth if the housing market really does slow significantly. Suppose the Federal Reserve reversed policy, would housing be quickly fine? What is there after housing?

[Dirk van Dijk]

Anne,
REITs trade on FFO (funds from operations) not on earnings. P/FFO has increased for most REITs over the last five years, but are no where near as high as 37x, more like 17x.

[Holly W.]

Anne, If the Hwang Smiths think housing is under-priced based on the rental value, I wonder what rent they think you can collect for a median-priced $400,000 house in the Boston area? And if a person is currently seeing more "For Rent" signs than she can recall at any one time in the past 20 years, what does that say about both the house and rental markets? I'm just musing here, since you posted that article ...

[ilsm]

Don't worry be happy!

I remembber the last housing cycle.

This looks to me like 1989!

[anne]

Dirk, I know you are right, but I have not found other valuation levels that are comparable to the present in a 30 year search.

Holly, here too, I agree with your suspicion and posted the article for comment rather than conviction. I do not understand the housing markets I know reasonably well.

[anne]

No; REIT valuations simply do not make sense to me, and I do not know how property and share prices can hold with a further long term interest rate increase. Please however argue with me on this, for I know when I am puzzled :) Then there is Boston, and there too I have little confidence in the housing or real estate market.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
12/31/05 to 4/04/06

S&P Index is 5.1
Large Cap Growth Index is 3.9
Large Cap Value Index is 6.3

Mid Cap Index is 7.9

Small Cap Index is 11.9
Small Cap Value Index is 10.8

Europe Index is 12.7
Pacific Index is 8.6
Emerging Markets Index is 14.7

Energy is 13.6
Health Care is 3.4
Precious Metals is 24.2
REIT Index is 11.8

High Yield Corporate Bond Fund is 1.7
Long Term Corporate Bond Fund is -3.8

[howard]

what i find odd here is that he ignored the effects of equity liquidation on consumption in recent years, while spying "real" income gains that aren't there for most people.

[calmo]

It's not that he is brainless, just that he puts his professional interests ahead of whatever ethics he has. The song he is singing ("Don't worry, be Happy" as ilsm puts it) masks what he is thinking: 'As long as enough people have confidence in the strength of the economy, as long as people don't panic just because they think they see an end to their shopping days, we might squeak through this yet.'
Hard to know what he really thinks --especially what happens to those people in the RE industry as the market cools, or what social ramifications are attached to a society where living standards might actually drop. Does he think this far? I have my doubts it's in this direction.

[groucho]

I, for one believe everything Lacker says. I also, believe everything Volker, Greenspan and Bernanke say.

I also believe what Clinton, Bush, Cheney and Rumsfeld say.

I also believe in the Tooth Fairy, the Easter Bunny and Santa Claus.

I also believe..................(fill in the blank)

[calmo]

You know, I like this opening "I believe..." sorta like "I have a dream..." [which is really what I want to say along the lines of Dr. King --with some gusto...but I am shy.]
But groucho (such an adolescent!) splashes it around ad nauseum, killing the poor thing almost immediately.
I need a core of belief statments, not about the world so much as about my hopes and expectations for it. This is not the same thing as saying I'm an old crank with a religious bent --I'm not religious. [I'm not baiting you proselytizers, honest.]
With Lasker, the beliefs are not personal. Not really. They are statements about the world that are carefully crafted to be self-fulfilling.
Like the doctor who tells his patient 'The slightest shock could kill you.',
only in reverse: 'Should this statement fail to allay your fears about the possibility of an impending pause in the current vibrant economy, an opportunity to take an extended vacation would not be ill-advised.'

I believe...sorta.