The distinguishing feature of the current transition is the magnitude of the adjustment in the housing market, which comes at the end of what has been an amazing, decade-long run. The homeownership rate increased by 4 full percentage points from 1995 to 2005, and the number of houses built per year increased by 46 percent over that 10-year period.

Some observers have called this extraordinary behavior of the housing market in recent years a bubble. I don't find that term useful or particularly accurate, since the behavior of housing appears to have been based on solid fundamentals.

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

Fortunately, despite the housing risks I have described, other sectors of the economy still look pretty good.  For the most part, consumers are still buying things.  Businesses are still investing in new plants and office buildings.  And foreign economic activity also remains strong, which provides an additional source of demand for our goods and services.  Certainly the tone in labor markets has been very positive lately.  Continued hiring suggests a high level of business confidence about economic growth next year.

            Think of it this way.  We seem to have two economies at work - the housing economy, which is experiencing a very large adjustment, and the "everything else" economy, which is performing fairly well. 

In fact, we seem to have a bimodal economy with a couple of weak sectors, and the rest of the economy doing just fine. Those two weak sectors are, of course, housing and domestic auto production. Autos seem likely to have only a short-lived effect. In the case of housing, we agree with the Greenbook assessment of housing activity and find it quite consistent with the reports of our contacts in this sector. Besides the falloff in activity, house-price increases have also slowed markedly. The Case-Shiller house-price index has been flat in recent months, and futures on this index show outright declines next year. However, equity valuations for homebuilders, as Cathy mentioned, have risen moderately in the past couple of months, following large declines over the previous year, and we interpret that as providing some indication that the expected future path of home prices has at least stopped deteriorating. Of course, housing is a relatively small sector of the economy, and its decline should be self-correcting. So the bigger danger is that weakness in house prices could spread to overall consumption through wealth effects.

Furthermore, there are some very important fundamentals that should continue to support housing demand. First, productivity growth should continue to bolster gains in wealth and income—some of which will be spent on housing. Second, the financial innovations that have led to more efficient mortgage markets and increased access to credit are here to stay. Third, financial conditions are not very restrictive—after all, 30-year mortgage rates currently are under 6-1/2 percent. Furthermore, there are no "extra" factors reducing the supply of credit—contrast today's environment with the 1960s and 1970s when there were regulatory ceilings on interest rates or with the early 1990's when there was the "capital crunch."

The way I look at the forecast and the situation with the economy is quite positive in the sense that what we’re seeing, really, is a return to normalcy and a more balanced economy. The excesses in the housing sector seem to be unwinding in an acceptable way, so I think it is quite reasonable in terms of the Greenbook forecast to think that the spillover here is not going to be a big problem because we’re actually moving resources from a sector that had too much going into it, into sectors that need to have more resources at the present time. So in that sense, I’m actually quite positive.

[T]he so-called “wealth effect” that links increases and decreases in house prices with rises and falls in consumer spending may not be as strong as some analysts suggest.  In our estimation, the run-up in housing values over the past several years did not spur much of a bigger-than-expected increase in consumer spending — if anything, the response was a bit on the low side compared to the historical average. So we wonder about how large a spending effect one should expect to accompany a fall in housing prices, if that were to occur. Clearly mortgage equity withdrawals have been sizable during the housing “boom,” but many of these withdrawals were used to reduce other forms of consumer debt and to make one-time improvements in the housing stock.  Indeed, as a result, overall household balance sheets today continue to look fairly strong.

By 2030, almost one in five U.S. residents will be 65 years or older.  Well before then, beginning in about 2018, Social Security will start to pay out more in ben­efits than it receives from payroll taxes.  Even before that, -- in the neighborhood of 2010 -- Social Security will start exerting upward pressure on the unified federal budget deficit as its surplus diminishes, with a consequent reduction in net public saving, absent changes in the program itself, increased taxes, or reduced spending on other government programs.  

The situation for Medicare is similar and, potentially even more serious.  Payroll taxes to cover Medicare expenditures are currently in surplus.  Over time, however, Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit prob­lem that analysts see as potentially greater in size and more difficult to deal with than that associated with Social Security.   Thus, despite the relatively benign federal deficit we currently see, it is clear the situation will worsen dramatically over the next decade.  And, unlike the late '80s when deficits became a national concern, there seems to be no political consensus on the nature of this problem or its resolution -- a fact that should be a concern to all of us.

While it's likely that the slowdown in the housing sector will have only moderating effects on economic activity and will continue to unfold in an orderly way, I should note that we can't ignore the risk that a more unpleasant scenario might develop. In particular, we have heard a lot in recent years about the possibility that there is a house-price "bubble," implying that prices got out of line with the fundamental value of houses and that the current softening could be just the beginning of a steep fall. While I doubt that we'll see anything like a "popping of the bubble"—in part because I'm not convinced there is a bubble, at least on a national level—it is a risk we have to watch out for.

One scenario that we have heard a lot about in recent years is the possibility that there is a house-price "bubble," implying that prices got out of line with the fundamental value of houses and that the current softening could be just the beginning of a more precipitous fall. While I seriously doubt that we'll see anything like a "popping of the bubble"—in part because I'm not convinced there is a bubble, at least on a national level—I certainly do acknowledge that there is more reason to worry that house prices would fall sharply than that they would rise sharply.

Part of this moderation in growth is coming from some easing in the extraordinary pace of home construction, sales, and price appreciation—a development we’ve been expecting for some time. Don’t get me wrong. I do not expect a sharp residential real estate correction, but I believe we should recognize that a slowdown in housing activity is very likely—and may have begun already.

On a macro level I believe the housing adjustment most likely will be orderly and with a limited impact on the overall economy...For one thing, depository institutions in the United States are well capitalized and hence well positioned to absorb any housing lending losses they may incur...More and more of the credit- and interest-rate-related risks associated with mortgage finance can be easily traded and have gravitated to those institutions best positioned to manage the risks.

Many jobs depend on home-related construction and mortgage businesses, and important industries in our regional economy such as durable goods and carpet production also rely on housing construction. But even if there were no growth in housing construction, the level is high enough now to support strong ongoing demand for home products and related goods. Furthermore, consumers will continue to remodel existing homes and replace worn-out appliances and furniture. Looking at the broader context of our diverse and dynamic economy, direct residential investment is only about 6 percent of GDP.

I just wonder about the consumer’s ability to absorb shocks. The buildup of home equity and the ability to borrow against it have helped individual homeowners when they have had layoffs, medical problems, divorces—all the things in life that create month-to-month problems for cash flow. With the growth of negative amortization, home equity is not being built up anymore. Negative amortization clearly helps consumer spending because consumers, in effect, have a smaller amount of their take-home pay that has to go to the mortgage payment every month, and so it is available to be spent elsewhere. It is probably a more pernicious type of home equity withdrawal because you don’t take an action to withdraw it. Now it is planned that you will have negative amortization. It clearly changes the way we look at the role of savings as a precautionary balance to get the consumer through bad times, and it also has long-run implications regarding the importance of asset values vis-à-vis default rates both for the banking sector and for the household sector. So the growing ingenuity in the mortgage sector is making me more nervous as we go forward in this cycle, rather than comforted that we have learned a lesson. Some of the models the banks are using clearly were built in times of falling interest rates and rising housing prices. It is not clear what may happen when either of those trends turns around.