[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.  

While much of the downshift in the housing market appears to have occurred already, some further softening in housing starts may yet lie ahead as the inventory of unsold homes is reduced to appropriate levels.

... I see the economy growing at a more moderate pace over the next few years than we saw in the past couple of years. But there are risks to this outlook. The first risk is that the weakness in the housing sector spills over to other sectors of the economy, depressing overall growth. The second risk is that inflation remains stubbornly high...

The most recent price statistics have been encouraging, but not convincing...

...[T]here is still a risk that the underlying inflation trend will not continue to improve; in which case, the FOMC will need to respond with the appropriate policy actions.

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.

Reports on housing activity have consistently come in a little worse than expected, though very recent data on home buying attitudes, new home sales, mortgage applications and slowly declining inventories of unsold homes suggest some bottoming out may be at hand. As of now, our best estimate is that the housing slowdown will shave a percentage point or so off GDP in the second half of 2006.

The outlook for real growth in 2007, then, is for continued strength in consumer spending and business investment to be partially offset, particularly early next year, by the drag from the housing market.  Growth will start the year on the low side, but should be back to about 3 percent by the end of next year.  So my best guess right now is that real GDP growth will average between 2 ½ and 2 ¾ percent in 2007. 

  Since the mid-'90s, the housing capital stock, which reflects - that's the number of homes in the U.S., as well as their size and quality - the housing capital stock has been growing around three percent per year...

     Over the past decade, the size of a typical new home increased nearly 20 percent in the United States, and many homeowners invested in home improvements and renovations. So, today, many middle-class homes are - have bigger kitchens, more bathrooms, and it's not uncommon to see state of the art media rooms. So, you've seen more homes being built, and larger homes being built.

     Nonetheless, with underlying housing demand growing at three percent per year, these very large gains that we've seen in residential investment, which averaged 8.5 percent a year between 2001 and 2005, they clearly could not continue indefinitely.

     Moreover, housing demand may slow to less than three percent, as demographics point to slower growth in household formation. So, as a result, we at the Chicago Fed accept some further weakness in residential construction.

Now, currently, we don't see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy overall. On balance, the 95 percent of the economy outside of housing remains on good footing. Employment has been increasing near its long run sustainable path. Productivity trends remain solid. Recent declines in oil prices should give household budgets a boost. Economic growth in other countries should increase demand for our exports. And current financial conditions are not very restrictive by historical norms.

     So, my baseline forecast is that GDP growth will pick up from the weak third quarter and average somewhat below its potential growth rate over the next year or so. Of course, that's an average. And I expect to see some volatility in those numbers.

...

Our estimate is for '07..., as I mentioned, growth would be slightly below potential, but it should be coming back to potential as we exit '07 and go into '08.

Although residential construction continues to sag, some indications suggest that the rate of home purchase may be stabilizing, perhaps in response to modest declines in mortgage interest rates over the past few months and lower prices in some markets. Sales of new homes ticked up in August and increased a bit further in September. The University of Michigan's survey of consumers shows an increase in the share of respondents who believe that now is a good time to buy a home, from 57 percent in September to 67 percent in November.

So far, the decline in the housing sector has had very limited consequences for other sectors, and I think the spillover effects of the housing downturn will be modest for several reasons.
 
First, the housing boom we experienced over the past few years was clearly unprecedented, and I think most people saw it as unsustainable. A second reason that I think the spillover impact of the slowdown in housing will be modest is that the modest declines in house prices are largely being offset by a strong stock market and strong income growth. Thus, household balance sheets are still healthy...

A second reason that I think the spillover impact of the slowdown in housing will be modest is that the modest declines in house prices are largely being offset by a strong stock market and strong income growth. Thus, household balance sheets are still healthy.

Finally, despite the increase in the fed funds rate, mortgage rates remain at relatively low levels and are lower than they were in 1999 or early 2000 by about 2 percentage points. What’s more, as mortgage rates have begun to move up from their historical lows, the percentage of people moving to long-term fixed rate loans has been rising.

Earlier, Poole said in response to an audience question that while the housing market's slump may deepen, central bankers shouldn't adjust interest rates unless the slowdown endangers the broader economy.
     ``We just don't know how much further the housing downturn has to go,'' Poole said. ``As long as the housing problem remains confined to housing, there is really nothing the Federal Reserve can or should do.''
     Fed policy makers are now giving the housing market what Poole said is ``special attention.'' Sales of new single-family home sales dropped 23 percent in the third quarter, and Poole said he's concerned about purchase cancellations by prospective home buyers. The U.S. economy, dragged down by housing, grew at a 1.6 percent annual pace last quarter. 

     The housing market is seeing ``significant price softness'' and may be weaker than it appears, and the level of concessions by home builders to buyers is also a concern, Poole told the audience.

As reported by Bloomberg News

I believe we are seeing a return to a more conventional level of housing market activity in which volume, inventories and time-on-market are closer to historical averages. This adjustment naturally involves a fair amount of uncertainty for market participants. Both buyers and sellers are probably more unsure than usual right now about where prices need to settle in order to clear markets. In the meantime, they are collectively engaged in a time-consuming process of discovering the prices at which expectations and plans of buyers and sellers are mutually consistent.

The adjustment in {residential} markets has proven to have been more rapid and deeper than many economists had predicted, and we have yet to see signs that indicate just how the process will work itself out.

[C]alculations about the sustainable level of housing starts based on demographic factors, such as population growth and household formations, suggest that starts may be closer to their trough than to their peak. Although such calculations are, in general, not particularly useful for near-term forecasting, they do suggest that any overbuilding in 2004 and 2005 was small enough to be worked off over coming quarters at close to the current level of housing starts.

Mr. Bernanke, answering questions after a speech in Washington, said the housing sector is undergoing a "substantial correction" that will likely shave about "a percentage point off growth in the second half of the year" from what it would otherwise have been "and probably something going into next year as well," estimates close to private forecasters' views. Mr. Bernanke also said there is "limited evidence" the falloff in housing activity had spilled over to other parts of the economy. "To this point, other parts of the economy are remaining relatively strong."

As reported by the Wall Street Journal