Everyone expected that New Home Sales would be weak, but not that weak. In May, new homes were selling at a seasonally-adjusted annual rate of 300,000, 32.7% below the 446,000 rate in April and even 18.3% below the very depressed levels of a year ago. Actually, given the huge downward revision to the April numbers relative to where we thought we were, sales were down more like 40.5%. The consensus expectation was that sales would fall to a 430,000 rate.
The reason everyone was expecting a decline was that new home sales are recorded when the contract is signed, not at closing as is the case with existing home sales. Thus, all the people who were taking advantage of the home buyer tax credit were recorded in April. Someone would have to be pretty stupid to sign a contract to buy a new house on May 1st rather than on April 30th.
As shown in the graph below (from http://www.calculatedriskblog.com/), this is an all time record low, with records stretching back all the way to the Kennedy administration. Between the days when the danger off our southern shores was missiles based in Cuba, and the days when the danger was a big oil slick, the population has grown from 188.1 million to the current 309.5 million. More people should mean more demand for places to live. During that time, mortgage interest rates soared as high as 18.45% (10/81), but still more new houses were sold than in May when a 30 year conventional mortgage could be had for 4.89%.
Clearly the tax credit did not create a lot of new demand; all it did was pull demand for houses that would have been bought in May or June into April. The vast majority of the houses bought would have been bought anyways. Also. the money spent on the tax credit is now tied up in the houses, and is not really circulating in the economy. If people are looking for a place to scale back on stimulus spending to address the deficit issue, the end of the tax credit (and telling proponents of extending it or bringing it back to sit down and shut up) would be a very good place to start. I don’t really doubt the intentions behind the tax credit, but it is a remarkably ineffective program.
Normally residential investment is the key locomotive that pulls the U.S. economy out of recessions. The leading relationship between new home sales and the overall economy simply screams at you when you look at the graph and the relationship between new home sales and the recession bars. New home sales have dropped sharply before every recession since new home sales have been tracked by government statistics, with the possible exception of the 2001 downturn. They have bottomed in the middle or right at the end of every recession, and increased sharply in the early phases of each recovery.
That simply is not happening this time around. For starters, the number of new houses built during the housing boom was simply off the charts. Housing is perhaps the ultimate durable good. Because durable goods last a long time, it is easy to cut back on buying a new one when times are bad, but when times are good people will splurge on them. This makes sales of durable goods, and especially housing, much more volatile than on non-durable goods that are used up right away or wear out very quickly.
Each new home sold means that homebuilders like Lennar (LEN) can start a new house without worrying about it simply sitting in inventory. Given how much each new home costs, the cost of carrying that inventory is very high. Each new house built generates an enormous amount of economic activity. It employs a lot of people: framers, plumbers, electricians and so on. When they are employed, they have the money to go out and spend on other things, like say going out to dinner. That stimulates employment of waiters and cooks and busboys. There is also a huge amount of material that goes into a house. That means good things for a wide range of companies, from Berkshire Hathaway (BRK.B), which among other things is a leading producer to bricks, to lumber companies like Plum Creek Timber (PCL) and makers of plumbing supplies like Masco (MAS). Most of that material is sourced domestically (or from Canada). That creates a lot of factory jobs at sawmills and employs a lot of lumberjacks. Those people also then have the money to go out to eat or shop at Wal-Mart (WMT). Thus residential investment is sort of the starter motor that gets the rest of the economy running again.
Used homes are very good substitutes for new homes. This time around we have a huge inventory of existing houses, especially when you consider the shadow inventory of houses that are in the process of being foreclosed on, or where the owners are far behind on their mortgage payments, but the banks have been slow to actually start foreclosure proceedings. Actual inventories of new homes have come down in absolute numbers, falling by 0.5% in May but down 26.8% from a year ago. In absolute terms, new home inventories are at their lowest level since 1970.
However it is important to measure inventories not just in absolute terms but relative to sales. The second graph (also from http://www.calculatedriskblog.com/ ) shows the months of supply of new houses at the sales rate of the time. After spiking down in April to 5.8 months as people rushed to get in under the wire and collect the tax bribe from Uncle Sam, the months of supply shot up to 8.5 months in May, although that is still an improvement over the 9.5 months of a year ago. During the housing bubble, the months of supply of new houses stayed around four months. We will probably not see that sort of level on a sustained basis any time soon. A more normal level is about six months, so with the temporary help of the tax credit, we got down to normal for a month.
A big part of the problem is that demand means more than just people wanting something. It is people wanting something and having the ability to pay for it. Yes the population has grown over the years. However, the rate of household formation has been extremely low. Recent college graduates are not finding jobs, and so they are returning to live with Mom and Dad after commencement rather than moving into a place of their own. People who have lost their homes to foreclosure are doubling up with friends and family (or living on the streets). Until the unemployment rate falls significantly, the rate of household formation will not start to increase.
However, as I just pointed out, housing is normally one of the key drivers of employment, especially in the early stages of a recovery. The construction industry has been particularly hard hit in this downturn. It has lost a total of 1.944 million jobs since the start of the recession (actually its worse since construction employment turned down before the rest of the economy started to lose jobs). That is more than a quarter of the jobs lost in the whole economy, even though at the start of the recession, construction was responsible for only 5.46% of all jobs. No jobs, no houses/No houses, no jobs. Chicken meet egg, egg say hello to chicken.
The effects of the housing bubble are still reverberating through the economy and likely will for some time to come. The decline in home values has wiped out the wealth of millions. One out of four homes with a mortgage is now “underwater” and in many states the number is far higher than that. Many of these people will decide that the only rational economic course of action is simply to stop paying on their mortgage and live there until the sheriff kicks them out (which in many areas of the country could mean living rent and mortgage free for well over a year). It is worth noting that the state with the highest percentage of underwater homes, Nevada, is also the state with the highest unemployment rate. Eventually though, those houses will come on the market, adding to the supply, and the new supply will drive prices still lower. That in turn will put more homeowners under water. Lather, rinse, repeat.
The good news is that relative to incomes and rents, the price of housing is back to about normal. They’re not particularly cheap, but no longer are they astronomically expensive. Eventually we will see a rebound in residential investment. Even getting up to what was considered a normal, not particularly good level of new home sales from the 1960s through the end 1980s would result in a doubling of new home sales from the current rate. Just when that will occur is hard to say. The much greater-than-expected collapse in new home sales in May significantly raised the odds that we will go into a double dip recession. It is a gale force headwind that is combining with the waning of the impact of Federal Stimulus spending, dramatic cut backs at the state and local government level, and aggressive (and misguided) austerity programs in Europe. I’m not yet in the double dip camp, but I have to say I’m getting closer to it.
By region, the worst hit was the West, where sales fell 53.2% in May from April and are 43.3% below year-ago levels. Next worst hit was the Northeast, where sales fell 33.3% on the month, but are up 12.0% year over year. In the South, by far the largest and most important of the four census regions, sales were down 25.4% for the month and are 16.7% below where they were a year ago. In the Midwest, sales fell 23.9% on the month but are up 6.3% from last year. Nationwide, the median price of a new home fell 1.0% for the month and is down 9.6% year over year. Average prices held up a little bit better, down 0.7% for the month and 4.1% year over year.
No matter how you look at it, this was a very bad report, and it is in a very important economic number. New home sales are far more important than used home sales. They directly impact GDP growth, while the effect of used home sales is mostly indirect. The silver lining is that it should force the Fed to ignore calls for an early tightening of monetary policy. Even with the Fed Funds rate at almost 0%, monetary policy is still too tight. The Fed needs to increase the money supply more. It also has to get banks lending again. One thing it could do is stop paying banks to sit on cash and not lend it out. Cut the rate paid on excess reserves to zero. They could also engage in quantitative easing, buying up longer dated T-notes (sure no shortage of those). Effectively doing that would be the same thing as turning on the printing presses. Potentially that would be inflationary, but inflation is not a real threat right now. Over the last three and six months, the core CPI has been zero. We are on the cusp of deflation.
There is a real cost to obsessing over the inflation boogeyman. That cost is paid by the millions of people who are out of work and would like to have a job. Almost half of them have been out of work for more than six months, and if nothing is done soon, millions of them are going to lose their last line of support when the extended unemployment benefit checks start to dry up. The prospect of real, third world style poverty is growing in this country. The formerly middle class people who are forced into destitution are paying a very heavy price for this fear of inflation. Also, this is not the time to be cutting back on Federal Stimulus spending. Yes the long term deficits need to be addressed, but cutting spending now is only going to further slow the economy. That will result in federal tax revenues falling even more. As it stands now, federal tax revenues were only 15.76% of GDP in the first quarter. The long term average is over 18%, and since 1950, tax revenues have fallen below 16% in only six quarters, including the last five.
There is a real danger that we will repeat the mistake of 1937 when FDR pulled back too soon on the New Deal and thrust the economy back into the depression after his first term produced the highest rates of GDP and industrial growth in the country’s peacetime history (rebounding from obviously very depressed levels). State spending cuts are going to lead to the layoffs of hundreds of thousands of teachers, cops and firefighters. Just how are we improving the future for our children if they grow up illiterate and innumerate?
There is no sign that the markets are about to lose confidence in the ability of the U.S. government to repay its debt as interest rates on treasuries, even long term treasuries, are at generational lows. The debt does not actually have to be paid back, it can and most likely will be rolled over. The U.S. has not totally paid down its debt since 1838, thus technically, we have never “paid back” what the Union borrowed to win the Civil War. The cost of servicing $1 Trillion of additional debt right now for ten years is less than 0.25% of GDP.
Unemployment is the real danger, not inflation. Policy makers need to address it, not be actively trying to make it worse by introducing austerity programs at this time.
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