July 28, 2006 (GDP Byte)
Weakening Housing Market Slows Economy
July 28, 2006
By Dean Baker
GDP growth fell to 2.5 percent in the second quarter as consumption growth slowed and housing investment fell sharply. Equipment investment also declined for the first time since the first quarter of 2003. While the growth data is somewhat worse than expected, the report also provides evidence that inflationary pressures are increasing.
The weak consumption growth is directly related to the weakness in the housing market. Consumers have borrowed heavily against the growing equity in their homes over the last four years, as the savings rate declined from 2.9 percent in the first quarter of 2002 to -1.5 percent in the second quarter of 2006. This drop in savings translated into more than $400 billion in consumption growth over this period. Now that housing prices have stopped rising, and may even be falling in real terms, consumers are losing the ability to borrow further against their homes. This means that the savings rate is unlikely to slide still further into negative territory. As home prices weaken, the savings rate will begin to rise to more normal levels, and consumption growth will trail income growth. If job growth and real wage growth remain weak, then this implies that consumption will grow very slowly or even decline.
Residential investment fell at a 6.3 percent annual rate in the second quarter, subtracting 0.4 percentage points from GDP growth. This decline is likely to continue for the foreseeable future, as housing construction remains more than 25 percent above its trend levels.
The weakness in equipment investment in the quarter was somewhat of a fluke, reflecting a comedown from an extraordinary 15.6 percent jump in the first quarter. Averaging the two quarters gives a 7.8 percent growth rate, which is probably close to the current underlying trend in investment. This is a respectable rate of investment growth, but it is not sufficient to offset weak consumption growth and the falloff in residential investment.
The most positive aspect in today’s report is the slight improvement in the trade deficit, as net exports added 0.33 percentage points to GDP growth. However, the improvement was due entirely to slow import growth, as export growth was down from the first quarter rate. Slow import growth is attributable to both weaker economic growth and also a decline in the value of the dollar, which is making imports more expensive. Non-fuel import prices increased at more than a 3.5 percent annual rate in the quarter.
This rise in non-energy import prices is one of the items in this report that raises concerns about future inflation. In addition, the weak GDP growth also implies slower productivity growth. With hours rising at close to a 2.5 percent annual rate, productivity growth is likely to be flat for the quarter. This is partly a fallback from the strong 3.7 percent growth in the first quarter, but productivity growth for the last year will still be under 2.0 percent. This is down sharply from the 3.7 percent annual rate of productivity growth from 2002-04. If productivity growth stays in the 2.0 percent range, it will provide less opportunity to offset rising oil and import prices.
The path forward from this report is not encouraging. The weakness in the housing market will persist for the indefinite future as the housing bubble continues to deflate. This means that home prices will decline further (at least in real terms, if not nominally), which will sharply curtail future borrowing. (Look to credit card debt to rise as consumers lose the ability to borrow against their homes.) Housing construction will continue on its downward path, as builders will cut back plans for future construction even as they rush to finish existing projects before the market weakens further.
At the same time, rising inflation, due to weaker productivity growth and rising import prices, is likely to push long-term interest rates still higher. Higher interest rates will in turn further weaken the housing market, amplifying the slowdown. This is a necessary adjustment process from an unsustainable bubble, but it is not pretty.
Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C.
CEPR’s GDP Byte is published quarterly upon release of the Bureau of Economic Analysis' report on the Gross Domestic Product.