Tuesday, 20 June 2006

Despite weakness in US housing, recession not yet inevitable

Will the current weakness in the United States housing market lead to a recession? The jury is still out on this.

The National Association of Home Builders/Wells Fargo Housing Market Index (HMI) -- a gauge of builder perceptions of current and future single-family home sales in the US -- showed a fall to 42 in June from 46 in May. The June reading is the lowest since April 1995 and is well down from its June 2005 peak of 72.

The trend in the HMI is similar to that of actual new single-family home sales. Despite a slight rebound in March and April, the number of new single-family homes sold in the first four months of 2006 have been eleven percent less than that in the corresponding period in 2005.

These trends show weakness in the housing market and do not bode well for consumer spending. The HMI and the number of new home sales have both correlated well with consumer spending in past cycles, as shown in the following chart.

Indeed, economic data released last week suggest that consumer spending, especially in real or inflation-adjusted terms, may already be slowing. May retail sales rose just 0.1 percent over April. The University of Michigan's index of consumer sentiment, although rising to 82.4 for June from May's final reading of 79.1, is still well below levels in the 90s or more that prevailed during much of the earlier part of the current expansion.

And consumer price inflation accelerated in May. Overall inflation rose to an annual rate of 4.2 percent in May from 3.5 percent in April while core inflation -- excluding food and energy -- rose to an annual rate of 2.4 percent in May from 2.3 percent in April.

Higher inflation hurts real consumer spending not only because nominal spending is offset by a larger inflation rate but also because it puts pressure on the Federal Reserve to keep raising interest rates, hurting the housing market and consumer demand.

However, while real consumer spending may be slowing, an imminent consumer-led recession is far from inevitable.

The above chart also shows that the extent of the downturn in the housing market so far is similar to that in 1994-95. At that time, the housing market weakened in 1994 as the Federal Reserve raised interest rates. However, by 1995, the Federal Reserve had stopped tightening monetary policy, allowing the housing market to recover. As a result, growth in real consumer spending stayed positive on a year-on-year basis throughout that period and there was no recession.

Today, with Federal Reserve officials publicly stating that they expect inflation to cool and most economists expecting just one or two more interest rate hikes from the Federal Reserve, there is a chance that the 1994-95 pattern could be repeated. That in turn means that a consumer-led recession could yet be averted.

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