Real GDP increased at a 2.2 percent rate in the third quarter. Similarly, the National Activity Index, which is a barometer of economic growth published by the Chicago Fed, has moved down in recent months, and the data for October were consistent with an economy expanding at below-average growth rates. Part of the slowdown reflects the natural moderation in growth.
A significant part, though, was due to developments in the housing sector. Residential investment has fallen 7.7 percent year-to-date, and in the third quarter it shaved 1.2 percentage points off of GDP growth. Additionally, home prices have been rising more slowly and by some measures have even declined. These developments raise important questions for the economy as a whole: Will there be further declines in housing markets? And will the current declines and any further declines in housing lead to more general economic weakness?
Here, it's important to remember the positive longer-run fundamentals underpinning housing demand. Since the mid-1990s, the housing capital stock—which reflects the number of homes in the U.S. as well as their size and quality—has been growing about 3 percent per year on average.
This demand for housing has been supported by the step-up in productivity growth, which improved the long-run income prospects for Americans. Furthermore, financial innovations lowered borrowing costs and greatly increased access to credit. As a result, the homeownership rate in the U.S. has increased from 64 percent in the mid-1990s to 69 percent in 2005, with improvements across nearly all demographic and income groups. And many people have put their money into bigger and better homes. Over the past decade, the size of a typical new home increased nearly 20 percent, and many homeowners invested in home improvements and renovations. Today, many middle-class homes have bigger kitchens and more bathrooms, and it's not uncommon to see some with state-of-the-art media rooms.
Nonetheless, with underlying housing demand growing 3 percent per year, the large gains in residential investment—which averaged 8-1/2 percent per year between 2001 and 2005—clearly could not continue indefinitely. Moreover, housing demand may slow to less than 3 percent, as demographics point to slower growth in household formation. As a result, we at the Chicago Fed expect some further weakness in residential construction.
By themselves, the declines in residential investment could contribute to some volatile numbers for overall GDP growth. But their direct impact on the economy is limited by the relative size of residential investment. Home construction is on average only about 5 percent of GDP—that's about the same as people spend on recreation items such as books, golf clubs, and tickets to theater and opera.
In order to generate more general economic weakness, the housing slowdown would have to spill over into other sectors of the economy. One avenue for this to occur is through home prices. We all know that home prices have soared during the past five years. The factors that caused fundamental increases in the demand for housing should be reflected to some degree in higher home prices. But there is still a risk that prices have also been boosted by factors unrelated to demand fundamentals. If that is the case, prices in some regions could unwind and reduce residential construction. And the negative wealth effects from softening house prices could reduce consumption more than anticipated.
Currently, we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy overall. On balance, the 95 percent of the economy outside of housing remains on good footing. Employment has been increasing near its long-run sustainable pace. Productivity trends remain solid. Recent declines in oil prices should give household budgets a boost. Economic growth in other countries should increase demand for our exports. And current financial conditions are not very restrictive by historical norms.
My baseline forecast is that GDP growth will pick up from the weak third quarter and average somewhat below its potential growth rate over the next year or so. Of course, that's an average—I do expect to see some volatility in the numbers.
Excerpt from a December 1st talk by Chicago Fed President Michael Moskow. Note the comment about house prices and the spill-over into the wider economy (emphasis added):