The collapse of the U.S. housing market was a critical cause of the Great Recession and sustained growth in this sector is necessary for the stimulus-driven economic recovery to succeed. After improving in late 2009 and early 2010, the housing market appears to be weakening again following the expiration of the homebuyer tax credit. Despite very low mortgage rates and improved affordability, home sales and prices remain depressed amid high unemployment and a large inventory of vacant homes persists. Beyond policies geared toward stimulating aggregate demand, there is limited scope for additional measures to aid the housing sector. Therefore housing will likely continue to lag behind the recovery rather than lead it.

Housing’s Aborted Recovery

Major housing indicators—including housing starts and existing home sales—have returned to low levels after showing signs of life several months ago. Though housing starts rose a modest 18 percent from December 2009 through April 2010 as the homebuyer tax credit was expanded, they are now at their lowest level in eight months and about 75 percent off their 2006 peak following the credit’s expiration.

Early signs of a recovery in existing home sales have also faded, with June’s 5.1 percent (m/m) decline marking the fifth downturn in the last seven months. While new home sales rose nearly 24 percent in June (m/m), the pace of sales remains slow: in annualized terms, sales in May and June were the slowest on record and remain more than 70 percent below their 2005 peak. Permits for new housing units are also low, suggesting that construction is not likely to rebound in the coming months.

Housing Market Indicators
	Most Recent Value	Date	Year Ago	Dec. 2006
Home Prices (indices)
Case Shiller (NSA, January 2000 =100)	146.4	May–10	140.0	203.3
FHFA (SA, January 1991 = 100)	196.0	May–10	198.4	221.3
Home Sales (thousands, annual rate)
New	330	Jun–10	396	998
Existing	5,370	Jul–10	4,890	6,460
Housing Supply
Existing Homes (months)	8.9	Jun–10	9.4	6.8
Housing Starts(thousands, annual rate)	549	Jun–10	583	1,649
Foreclosure (thousands)
Foreclosure Filings	313	Jun–10	337	109
Underwater Borrowers	11,277	Q1 2010	10,163	...
Mortgage Rates (30-Yr FRM, percent)	4.56	Jul–10	5.25	6.18
Unemployment Rate	9.5	Jun–10	9.5	4.4
Sources: Bloomberg, National Association of Realtors, U.S. Census Bureau, Federal Housing Finance Agency (FHFA).

Although home price indices have risen recently, the price recovery remains hesitant. After sliding sharply for several months, the Case-Shiller Home Price Index has increased by between 2 percent (y/y) and 5 percent (y/y) every month since February. Despite this improvement, the index is not far from its 2009 low and remains about 30 percent below its peak in 2006. The FHFA house price index, the other major price indicator, is also down 12.3 percent from its peak in 2007. Some regions are recovering more strongly than others. While prices in Denver and Dallas are only 5 to 9 percent down from their peak, prices in Phoenix, Miami, and Las Vegas—among those hit hardest by the housing crisis—are down by 48 to 57 percent from their peaks in 2006.

Fundamental Weaknesses

While improved affordability—due to low mortgage rates and low home prices—and the federal homebuyer tax credit were vital to housing’s early rebound, underlying factors needed for a housing recovery are still lacking. In particular, weak labor market conditions, the housing sector’s slow adjustment to current conditions (seen in the large inventory of unsold homes), and surging foreclosures will continue to weigh on the housing market.

High unemployment poses one of the biggest impediments to a recovery, as seen during previous housing cycles. Following the end of the recession in the early 1980s, for instance, unemployment quickly fell and new home sales rose sharply—about 70 percent—during the next two years. After the recession in the early 1990s, on the other hand, unemployment continued to creep up for 15 months while home sales grew just 26 percent over the next two years. Unfortunately, the current unemployment rate is projected to remain high—9.7 percent in 2010 and 9.2 percent in 2011. Unless the economy starts to add a significant number of jobs, sustained improvement in housing is unlikely.

The large inventory of unsold homes poses another obstacle. The ramp-up in construction during the housing boom—combined with the slowdown in household formation¹ during the economic downturn—has inflated the inventory and put downward pressure on prices. The inventory currently stands at 8.9 months of supply, compared to less than 6 months in a normal market.

Decreased demand is partially responsible for the increase in inventory. According to the Mortgage Bankers Association, approximately 1.2 million households were lost from 2005 to 2008 (reflecting such factors as young people returning to live with their parents and migrants going back to their homelands) and house-owner household formation fell by about 1 percentage point. Given the depth of the downturn and the labor market’s continued weakness, household formation is expected to slow further.

A rise in foreclosures also contributed to the large inventory of unsold homes. Lenders took control of nearly 528,000 homes in the first six months of this year. If foreclosures continue at that rate, that number will reach more than 900,000 in 2010—far higher than the historical average of 100,000 per year.

A Drag on GDP

While a recovery in the housing market helped lead the economy out of previous recessions, housing starts are lagging behind economic activity this time.

Residential fixed investment—which consists, among other things, of investment in new construction and improvements of housing units—supported growth in the third and fourth quarters of 2009 but contributed negatively to GDP in the first quarter of 2010. Recent data indicates that housing might continue to be a drag on the economy in the following quarters. In the second quarter, residential construction slumped after the tax credit for homebuyers expired in April and housing starts are estimated to have fallen by an annualized 10 percent (q/q). According to IHS Global Insight, residential investment could subtract from economic growth in the third quarter.

Housing's Contribution to GDP
	2005	2006	2007	2008	2008Q4	2009Q1	2009Q2	2009Q3	2009Q4	2010Q1
Percentage of GDP	6.1	5.5	4.4	3.4	2.8	2.8	2.7	2.8	2.8	2.7
Contribution to GDP Growth ( % points)	0.4	-0.5	-1.1	-1.0	-0.8	-1.3	-0.7	0.4	0.1	-0.3
Source: US Bureau of Economic Analysis.

A recovery in housing would help boost consumer durable purchases (which respond to wealth effects and the availability of home equity loans), corporate profits, and jobs linked to the housing industry. According to Moody’s, cuts in spending by homeowners shaved 0.8 percentage points from GDP growth last year, accounting for more than 30 percent of the decline in GDP. More recently, retail sales fell by 1.2 percent in May, led by a 9.3 percent decline at building-material stores. While the modest improvement in personal disposable income—which rose in six of the seven months through May—will help, lower housing wealth and a weak labor market continue to constrain household spending.

Policy Recommendations

The decline in housing activity after the federal homebuyer tax credit expired raises the question of whether the housing sector is strong enough to stand on its own. Further government support is unlikely, however, as policy makers turn their attention to cutting the budget deficit. At the same time, while federal support could nudge housing demand by encouraging consumers to buy now, it would likely be at the expense of demand later.

Unlike general tax cuts—which provide more neutral support to the economy—support for the housing sector distorts the market. Temporary tax credits will not solve the housing market’s fundamental problem—the large unsold inventory that is depressing sales and prices. Indeed, such policy could make the problem worse by encouraging more homebuilding.

On the other hand, policies that aim to prevent “unnecessary” foreclosures (where the household has the means to pay its mortgage if given enough time) have large positive externalities: they allow people to adjust to temporary shocks, minimize transaction costs in the property market, and stabilize the surrounding community. However, because such policies are difficult to execute, and job losses drive a significant percentage of foreclosures, general-demand stimulus measures and those that foster job creation may be the best approach.

Shimelse Ali is an economist in Carnegie’s International Economics Program.

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^{1. A transition from a shared living arrangement, with parents or others, to an independent renter- or owner-household.}