Chances rise for housing-driven recession http://today.reuters.com/news/newsA...01_N27446048_RTRUKOC_0_US-ECONOMY-HOUSING.xml Tue Jun 27, 2006 4:55 PM ET By David Lawder - Analysis WASHINGTON (Reuters) - The U.S. housing market is now tracing a clearly downward trajectory that economists say will steepen as interest rates rise, raising chances of a recession by early 2007. The key will be the extent to which the slowdown in sales activity translates to a decline in selling prices, eating away the cushion of home wealth and spending power that U.S. consumers have accumulated in recent years. Merrill Lynch economists say there is now about a 40 percent chance of a recession in the first half of 2007 -- even without a widely anticipated 25 basis-point Federal Reserve rate hike this week. As much as half of U.S. economic growth is now directly or indirectly related to housing sales, construction and consumer spending fueled by home equity extraction, said Sheryl King, senior economist at Merrill Lynch. "If that stimulus is withdrawn, it provides a notable danger to economic growth," she said. "The higher the interest rates go, the higher the chance that the housing market cools more abruptly and you get an outright decline in home prices." Bernard Baumhol, executive director of The Economic Outlook Group in New York, said he believes chances of a recession in 2007 will increase to 35 percent if the federal funds rate -- at 5.0 percent going into this week's Fed policy meeting -- exceeds 5.5 percent. "If the Fed gets to 6 percent, we're probably talking about a 50 percent probability of a recession in 2007," Baumhol said. "The reason for that is that the Fed is raising rates at a point when the economy is already slowing down and past rate hikes have not yet had their full restrictive effect." PRICE DECLINES LOOM Higher mortgage interest rates will more quickly exhaust remaining buyers' ability to afford homes, causing unsold homes to pile up and prices to weaken -- a phenomenon that the National Association of Realtors said on Tuesday is already happening in some overheated markets such as south Florida. The U.S. supply of unsold homes in May reached 6.5 months, the largest since May 1997, according to NAR data that showed a 1.2 percent decline in May sales, but slight gains in national median home prices. The Realtors chief economist, David Lereah, said an unprecedented national decline in prices is highly unlikely, given a solid underlying economy and still-strengthening real estate markets such as Texas and North Carolina. But many economists say the double-digit price gains in recent years represent an unprecedented situation that must be corrected. "We're going to see the oversupply get worse until we do see a very sharp reduction in prices," said Dean Baker, co-director for the Center for Economic Policy in Washington and a longtime housing bear. "That's my basis for saying we're looking at a very bad situation here which almost certainly will mean a recession." HOUSING ROCKET MAN Ed Leamer, director of UCLA Anderson Forecast in Los Angeles, likens the housing market to a powerful rocket that's out of fuel and is starting to succumb to gravity. Odds are that it will crash back to earth rather than make a widely predicted "soft landing", he said. All major housing booms in the past 45 years have ended with peak-to-trough activity declines of more than 50 percent except one. In 1967, a rapid increase in federal spending for the Vietnam War provided new fuel for a sputtering housing rocket. Such a stimulus won't likely be available to reverse the current downturn, given huge federal deficits, he said. But with still-healthy job creation, strong corporate profits and business investment spending on the rise, the soft-landing scenario for U.S. housing has many followers outside of the National Association of Realtors. A housing-driven recession is "mathematically impossible," said Wachovia Bank senior economist Mark Vitner, because housing is derived from the rest of the economy and construction is actually a smaller portion of the U.S. economy than during the housing boom of the late 1970s. Even if home values soften in expensive markets, many homeowners are still sitting on substantial home equity cushions. Leamer said home prices are somewhat sticky on the downside, due to the emotional attachment owners have with their homes. Many sellers would prefer to sit out slow periods than cut prices. He believes the U.S. will barely avoid a recession next year because the housing slowdown is unlikely to be accompanied by a precipitous fall in manufacturing employment as in past recessions, partly because so many manufacturing jobs have been sent overseas. Rather, he sees housing weakness spreading a "long malaise" over the economy which will slow gross domestic product growth to the 2 to 2.5 percent range for the next year, compared with 5.3 percent for the first quarter of 2006.