Looking ahead, it seems likely that the period of house price declines will not be over very soon, since some models of the fundamental value of houses suggest that prices are still too high, and futures markets for house prices indicate further declines this year.

Looking ahead, my forecast has been affected both by an economic slowdown that has been sharper than I had expected and the recurring spells of financial market turmoil. A few months ago our forecast at the Atlanta Fed saw growth slow in the first half of 2008, then pick up in the second half of the year. But it now appears to me that the contraction in housing and the dampening effects of financial turmoil on household and business spending could persist through the remainder of this year. The recovery in growth I had expected in the second half of this year may be delayed.

The tax rebates should provide some stimulus in the second and early third quarters of this year. But given the uncertain atmosphere I expect will continue to prevail in May and June, I do not expect full flow through of the rebates into personal consumption expenditures.

I expect it will take much of the rest of the year for house prices to bottom out and financial markets to restore the necessary preconditions of stability—that is, confidence in asset values and confidence in transaction counterparties.

Looking ahead further to 2009, my outlook becomes more optimistic. It will take longer than I earlier expected to return to solid growth, but by the fourth quarter of 2008 the conditions should be in place to support a return to healthy growth next year.

The housing sector has been and will continue to be affected by the tightening we've seen in lending standards. New home sales have fallen 64 percent from their peak in October, 2005. Home construction is unlikely to bottom out this year, and I expect housing investment to continue to be a drag on growth through at least year-end.

Despite the positive readings on recent economic performance outside the housing sector, my forecast calls for below trend, slower GDP growth in the fourth quarter of 2007 and first half of next year. This forecast anticipates further weakness in housing in the near term and the likelihood that declines in housing wealth will contribute to a weakening of the pace of consumer spending.  

Residential investment has been a major source of weakness in the economy for a year and a half. Forecasters who were predicting a recovery in the housing sector by the end of this year have been revising down their forecasts to incorporate the effect of rising mortgage defaults, financial turmoil, and softening housing prices. Particularly notable is the decline in housing prices in many regions of the country. Consumer spending is affected by households net worth and housing equity is an important component of wealth. While the effect of the problems in housing on consumption has been muted to date, further and more widespread deterioration in housing prices would increase the risk of a more adverse impact on consumption.

Current difficulties afflicting the real estate sector have, to date, been confined to the residential sector; business outlays for structures have been quite strong. Since its peak in 2005:Q4, real residential fixed investment expenditures have declined by 19 percent. Over the same interval, real business investment in structures has increased by 21 percent. If you plot these two series on a chart, they would look like scissors: one line going up and one line going down—and their slopes would be quite steep. Indeed their slopes suggest that the current rates of change are not sustainable. Housing will not continue to fall at double-digit rates, and outlays for business structures will not continue to increase at double-digit rates.

Unfortunately, recent events suggest that housing will remain weak for several more quarters; stabilization may not begin until well into 2008. Probably the most important statistics in this regard are the number of unsold new homes still on the market relative to their current sales rate and the recent trends in house prices.

In the U.S., the recent reversal of the boom in housing activity and house prices has contributed to a slowdown in economic growth. But the consequences of the declines in housing activity and house prices, in my view, have so far not derailed the prospect that economic growth will return toward trend at the end of 2007 and in 2008.

[On housing] we're pretty close to a bottom in terms of demand, but there are some risks to that outlook.

As reported by Bloomberg News

More recently, some home builders have reported tentative signs of stabilization in demand, and some data—for example, applications for mortgages and sales of existing homes—are consistent with this assessment. Furthermore, conventional mortgage rates remain low by historical standards, lending support to housing demand. However, other data are weaker, such as the inventory of unsold new homes, which has increased further this year. Unless sales rebound dramatically (and unexpectedly), construction will be depressed for some time in order to reduce inventories to more desirable levels.

...After considering the various developments, including the problems in the subprime mortgage market, I expect that residential construction will stabilize as we move through 2007. However, it could be next year before we see any noticeable increases in home building.

Even if the demand for housing falls no further, weakness in residential construction is likely to remain a drag on economic growth for a time as homebuilders try to reduce their inventories of unsold homes to more normal levels.

A key question for the outlook is: What will be the full extent of the housing slowdown?

The most recent data on housing have been mixed and downside risks remain...

That said, the longer-term fundamentals for housing in the U.S. remain positive. The same factors that supported the housing boom—strong productivity trends and low borrowing rates relative to historical norms—are still in place. These factors likely put a floor under how far housing will decline. So I think home building will stabilize as we move through the year, but I don't expect to see any noticeable increases, either.

Home sales have steadied somewhat after falling sharply for a year or so. Considering this in combination with the continued drop in housing starts that I mentioned earlier, it is not surprising to find that inventories of unsold homes have begun to shrink. This development suggests that the process of resolving the imbalances between demand and supply in the housing market may be underway, and, as a result, we could very well see the drag on real GDP from housing construction wane later this year.

We have seen tentative signs that housing has begun to stabilize. Housing starts ticked up in November and December, new home sales increased in the fourth quarter, and applications for home-purchase mortgages have been running higher than they did last fall. And the same factors that supported the housing boom—strong productivity trends, improved access to credit, and low mortgage rates relative to historical norms—are still in place. These factors likely put a floor under how far housing will decline.

But after ticking up in November and December, housing starts declined sharply in January. These numbers can be highly volatile—especially during the winter months. Indeed, permits for home building also fell, but by a much smaller amount. But these data highlight that downside risks remain. Although demand is improving in some parts of the country, the progress is uneven. One national home builder recently reported that it has yet to see any stabilization in some Midwest markets, including Chicago and Detroit. Moreover, nationwide inventories of unsold homes remain much higher than they were a year ago. It will take some time for the excess inventory of homes to be sold. So while I think homebuilding will stabilize as we move through the year, I don't expect to see any noticeable increases, either.

[T]he recovery path of the housing market is a major source of uncertainty in forecasters’ outlook for the 2007 economy. It is a source of uncertainty for me as well. But I think both the economic fundamentals and the data we have seen thus far point to gradual improvement in the housing sector over the course of 2007.  

In my own judgment, housing starts may be not very far from their trough, but the risks around this outlook still are largely to the downside. Although house prices nationally have decelerated noticeably and appear to have fallen in some markets, they are still high relative to rents and interest rates. Building permits decreased substantially again in November, and inventories of unsold homes have only started to edge lower. We also do not know whether the possible stabilization that seems to be taking hold would be immune to a rise in longer-term interest rates should term premiums increase or the federal funds rate fail to follow the downward path currently built into market expectations. Even if starts stabilize at close to current levels, those levels are sufficiently low that overall construction activity would remain a negative for the growth of economic activity in the first half of this year.