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Housing: Growth's Shaky Foundation?

By Christopher Palmeri Will the housing boom end, rocking the national economy in 2005? That's the contention of the Anderson Forecast, the economic forecasting group at the University of California, Los Angeles, which correctly called the 2001 recession. In a recently released report, Edward Leamer, forecast director, said he sees rising interest rates and a slowdown in housing activity knocking U.S. growth down to 2.8% next year, below the consensus 3% rate.

If that weakness continues into 2006, the nation could see a return to the gloomier, shrinking economy of three years ago, Leamer figures. "We're talking a recession driven by a plunge in consumer spending on homes and durables," he writes.

Leamer expects the housing sector slowdown to begin in the second half of next year. He says the industry has remained strong because mortgage rates have stayed low. But more recently price increases have slackened, and the time it takes to sell homes has increased. The housing slowdown will spill over into other markets. "People started feeling wealthier," he says. "They have been buying SUVs. The loss of that wealth effect will slosh into a lot of other markets. We'll see some slowdown in other sectors."

FLATTENING OFF. Housing markets have been on a tear in recent years. Leamer calculates that in fast-appreciating markets such as Orange County, Calif., the ratio of median home prices to rent for a 1,500-square-foot apartment -- a statistic he calls the price-earnings ratio for homes -- has doubled over the past eight years to nearly 25 times.

American workers now spend an average of $3,800 per year buying newly built homes or remodeling existing ones. That's a 90% increase over the past decade. The hot residential market has also been a boon to payrolls. So far this year, construction jobs nationally have risen 3%, twice the employment growth of the U.S. overall.

Leamer says the federal funds rate, a key short-term interest rate controlled by the Federal Reserve, will rise beyond 2.5% from this year to the next. If that happens, new housing starts could slow to a rate of 1.8 million in 2005 and 1.6 million in 2006, he predicts. That's down from 1.9 million this year. Leamer also expects average new home prices to stay flat at $214,000 from 2005 to 2006. Prices had risen more than 33% in the past five years.

NO MOMENTUM. The loss of home appreciation -- and the related spending it encourages -- could suck $150 billion out of the economy, Leamer figures. That's more than the $106 billion drop in business spending on equipment and software that prompted the 2001 recession.

Ironically, the UCLA economists are predicting better times ahead for their home state. California's tech-induced troubles held back the rest of the nation in the past few years. The Anderson Forecast projects 1.6% employment growth for California in 2005, double this year's rate.

Still, Leamer is consistently curmudgeonly. He has been calling for the end to the housing boom for some years now. The difference now is that rising rates now seem to support his thesis. That could mean slower growth and perhaps even trouble ahead for the U.S. economy, which hasn't been able to build momentum during this economic expansion.

Leamer, 60, says he has bought and sold several homes since moving to Southern California in 1978. He notes: "Now maybe you'll be able to find a contractor in Los Angeles." Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau

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