The housing market represents the most significant downside risk to the US economy. Residential investment has marked a negative contribution on output growth since 2006. The housing sector's outlook is not optimistic given the high level of inventory overhang and tight credit conditions. Further deterioration in the market could drag the US economy lower, and a recession could not be ruled out unless the Fed takes aggressive action to stimulate growth.

Demand for housing is weakening

Demand for housing has been significantly weak. Sales of new homes have declined 45% and sales of existing homes have dropped by 30% from their peaks in mid-2005. Moreover, readings on both indicators have continued to fall over recent months, indicating that the demand would soften further in the near future.

A counter-argument is that solid growth in incomes and a fall in house prices should help boost the housing demand. The Composite Housing Affordability Index, compiled by National Association of Realtors, rose for two consecutive months, from 103.6 in July to 114.8 in September, indicating that a family is more likely to be able to afford a median priced existing home. However, the index stays at a relatively low level compared to the period of 2000 to 2005. In addition, the downside risks to the economy are rising. It is a question whether a family would buy a house under the current market situation even with higher incomes.

Home prices slowed in late 2005 and began to slide in mid-2006. The S&P/Case-Shiller Composite 10-City index, a measure of house prices in the US, has decreased by 5% in August compared with a year earlier. In addition, this trend seems to persist for a period of time. The CME Composite Housing Index Futures, which reveals market expectations of price movements, is currently suggesting that home prices would continue to decelerate before stabilizing in 2010. Potential homebuyers are therefore likely to defer their decisions to buy a house with this consideration.

Some people may argue that Federal Reserve's interest rate cuts would result in lower mortgage rates, which should support the demand for housing. However, the mortgage rates are not as sensitive to the movements of the Fed funds target rate as expected:

The table above shows that the magnitude of change in mortgage rates was much smaller than that in the Fed funds target rate. For instance, when the Fed tightened monetary policy between June 2004 and June 2006, raising its benchmark rate from 1% to 5.25%, interest rates on 15-year floating rate mortgages only went up by 80bps points during the same period. Similarly, when the US central bank shifted to an easing bias in response to the financial turmoil earlier this year, the cumulative 75bps reduction in the target rate only had minimal impact on mortgage rates.

More importantly, the policy shift in September has led to further weakness in the US dollar and sparked fears over inflation. This has prevented yields for longer-term bonds from falling as quickly as the benchmark rate. As fixed-rate mortgages are largely affected by long-dated bond yields, a steeper yield curve is somehow like setting a minimum level under mortgage rates. This may also complicate existing problems in the housing market where subprime mortgages are undergoing their interest rate reset.

Tighter lending standards on mortgages may discourage eligible homebuyers from applying, and as a result, exert some restraint on demand for housing. A Federal Reserve survey on bank lending practices in October showed that a significant number of domestic banks had tightened lending standards for prime, nontraditional, and subprime residential loans. That may have a negative effect on housing activity.

As a consequence of these developments, housing demand is expected to weaken further. A remark here is that housing could be an investment asset and therefore some demand is attributed to speculative reasons. Nonetheless, it is difficult to prove that the housing market boom in the past few years resulted mainly from increasing speculative demand. Even assuming this is the case, expectations of further price declines would also reduce investment demand and therefore does not change the conclusion of waning demand for US housing.

Housing supply is plentiful

In terms of supply, homebuilders have scaled back construction in response to weak home sales. Single-family housing starts have been down by 46% since January 2006. The level of building permits, a forward-looking indicator, continued to suggest further contraction in construction activities. That points to a drop in housing supply in future.

In spite of a slowing pace of homebuilding, the number of houses for sale remains elevated. The inventory of unsold new homes climbed to about eight months of sales, which is above the historical average of six months; and the inventory of existing homes for sale reached the highest level since 1999. In this context, the housing supply is more than sufficient to meet demand in the short term.

During the past two years, delinquencies and foreclosures on subprime adjustable-rate mortgages (ARMs) rose sharply compared with their lows in June 2005. According to the Federal Reserve, nearly 450,000 subprime mortgages per quarter, on average, will go through their mortgage rate reset next year. The foreclosed properties available for sale could increase the housing supply further. The US government has recently introduced a housing rescue program which provides relief to subprime borrowers by freezing their interest payments at the low starter rates for five years. That could reduce the number of foreclosures. However, supply for housing is still plentiful given the high level of inventory of unsold homes.

The housing downturn is yet to reach bottom

Weakness in the housing market has been a drag on the US economy for some time. There is no precise answer to the timing of an end of the housing cycle. In the last housing market recession, which began in the third quarter of 1986 and ended in the first quarter of 1991, it took more than four years to reach bottom. If history repeats itself, this cycle may hit the trough in early 2009. Another indicator is expectations of home prices, which according to the futures market, could continue to decelerate until 2010. Therefore, the housing downturn has some way to go before reaching bottom. This would further slow down economic activity. The Federal Reserve is expected to ramp up its efforts to prevent the economy from falling into a recession by reducing the borrowing cost aggressively, and the impact remains to be seen.