by Jason Jenkins Tuesday, February 28, 2012

The Federal Reserve, Housing and Monetary Policy

Housing is an important component of the national economy. Many investors notice the stock market moves every time housing data is released… but why?

Since the end of World War II, residential fixed investment (new home construction and remodelling spending) has accounted for nearly 5% of the United States’ GDP. But total housing expenditures – which include residential fixed investment, as well as rents, furnishings and other housing-related expenditures – have accounted for about one-fifth of total GDP.

What it Means to the Recovery

Historically, the housing sector has been a necessity to past economic recoveries as a whole. During the past nine recessions, the housing sector accounted for about 16.5% of economic growth in the first year of recovery.

The housing market will see a modest rebound in 2012. But given the depths to which the market fell in 2011, the recovery won’t feel very good to those in the real estate business, economists said earlier this month at the International Builders Show.

David Crowe, Chief Economist for the National Association of Home Builders, said housing starts are likely to jump to 700,000 units from 600,000 in 2011, with single-family starts reaching just about 500,000. Existing-home sales for the year should climb to 4.4 million from 3.8 million in 2011, he predicted.

“But we are going from the worst year for starts ever, or at least as far back as we can go to 1942, and the worst year for new-home sales since we started collecting that data,” he said. “This is not going to be a great year.”

The Importance of Housing

The housing market’s importance far exceeds some percentages of GDP. As the aforementioned numbers show, without housing participating in economic recovery, a meaningful economic recovery would not be possible.

Housing is relatively labor intensive. Nearly 12.5% of jobs were estimated to be related to housing during our last boom – which also includes employment tied to housing finance, such as mortgages. And take this into consideration; construction workers earn 25% to 30% more than the average pay in the economy.

And as housing goes, so does the rest of the U.S. economy. As the value of housing increases, the wealth effect kicks in. It’s estimated that consumers eventually spend as much as 5% of the increase in the value of their homes. For example – and I know this may be hard to reflect upon – during the previous decade’s housing boom, households used home-equity loans to boost their spending. A 5% increase in housing net worth, or about $1 trillion, coming from housing could boost consumer spending by $50 billion. This is a pretty good jumpstart to a fledgling economy.

The Fed and Monetary Policy

Housing is an important channel through which monetary policy affects the economy. A study at the Federal Reserve points out that the effect through housing accounts for about a quarter of the total responses of the economy to changes in monetary policy. Through the two rounds in Quantitative Easing, the Fed has poured in around $1.5 trillion of liquidity into the economy. In addition, the “Operation Twist” has lowered long-term interest rates including mortgage rates.

So, like it or not, this is what the Fed is trying to do with its policy. If we can somehow get house prices to stabilize, then banks would gain the confidence to lend money. Falling house prices and ever-increasing defaults have created banks with short arms and deep pockets. The tightening lending conditions have restricted consumer spending and slowed economic recovery .

Once houses begin to sell better as a result of rising prices and easier bank lending conditions, people will spend more money on furniture, landscaping, painting, remodeling, etc. A U.S. government study shows that a new homebuyer spends an additional $5,000 in the first year with the existing buyer spending about $3,700 more.

The Federal Reserve believes with no real fiscal policies coming from Capitol Hill to help the housing market. their monetary policy is the only game in town. Look for future policy moves and suggestions by Mr. Bernanke because they may have a significant effect on foreclosures and multi-family home building.