The Fed's Squeeze Play Is Crimping Housing

When is a house not a home? When economists start looking at it. Then it becomes a source of jobs for carpenters and masons, a reason consumers buy furniture and appliances, and a generator of utility and maintenance bills. Add it all up, and some 15% of all economic activity revolves around the housing sector.

Housing is also something more. It's always the first sector to bend to the will of the Federal Reserve. When interest rates were low in 1993 and early 1994, residential construction alone contributed 10.5% of the increase in real gross domestic product, not to mention all the secondary impacts. Since the first quarter of 1994 when the Fed started to lift rates, homebuilding has flattened out, contributing nothing.

This year, housing's performance will help determine how successful the Fed will be in bringing the economy in for a soft landing. That's because the latest news on durable goods shows that capital spending is still flying high. And the evidence remains mixed on whether the recent consumer slowdown is temporary or lasting.

TO BE SURE, housing is feeling a tug from the Fed's seven rate hikes in the past 14 months. Sales of new single-family homes held up surprisingly well last year, but they tumbled 14% in February to an annual rate of 551,000. Sales are now 20% below a year ago.

Home buying fell in all regions, and sales in the West plummeted 28.5%, partly reflecting California's heavy rains and flooding. The February drop left builders with a 7.7 months' supply of unsold homes, the most since the tail end of the last recession four years ago.

Existing home sales are also taking a big hit. Resales dropped 5% in February, to an annual rate of 3.43 million, the lowest pace in 21/2 years. The decline is evident across all regions, but again the West has fallen the most, with sales down 18.9% from a year ago.

That's not to say that housing is falling out of bed. Ironically, the recent bond-market rally, which has pushed down long-term interest rates in response to signs of an economic slowdown, is actually helping to prop up home buying (chart).

Mortgage applications to buy a home have surged 27.6% from mid-January to mid-March. That's right at the time when rates on a fixed, 30-year mortgage were slipping below 9% for the first time in nearly 4 months. The lending rise suggests that sales for both new and existing homes probably will stage a rebound in one or two of the spring months.

But any rebound may be short-lived, since interest rates can carry home buying only so far. The other key factor is income--and the Fed is looking to hold down job and income growth to keep inflation modest. If the Fed is successful, the trend in housing will remain lackluster over the course of 1995.

Already, builders are tabling new projects--not surprising given the heavy inventory of unsold homes. The Commerce Dept. revised its data on building permits to show a 1.2% drop in February, instead of a 0.6% fall. And the F.W. Dodge Div. of McGraw-Hill Inc. reports that the value of new residential building contracts fell 2% in February. Total contracts rose 5%, boosted by business construction and public works.

THE LATEST JUMP in consumer optimism, though, adds to the debate over whether or not the Fed is achieving its slowdown goal. One hour after Fed officials sat down to their Mar. 28 policy meeting, at which they agreed to leave rates alone for now, the Conference Board reported that its index of consumer confidence rose to 101 in March, from 99.4 in February. The high level is consistent with a "reasonably strong" economy, says the Board.

However, consumers' view of the economy is diverging by a widening margin when it comes to assessing the present vs. the future (chart). The Conference Board said the current-conditions component of the confidence index climbed to 117.1 from 112.2 in February, while expectations about the future slipped for the second consecutive month, falling to 90.2 from 90.8.

Buying plans rose in March, after sliding in February. Plans may have picked up because hiring remains healthy. The Board said that 23% of consumers think jobs are "plentiful." That's up from recent months.

Moreover, the eventual receipt of delayed tax refunds could provide some consumers with the cash to keep on spending. The Internal Revenue Service is trying to detect fraudulent tax returns by matching up Social Security numbers. So, through Mar. 10, the processing of 4.6 million tax returns had been delayed, and refunds were running about $5.9 billion--or 20%--below last year's pace.

THE IRS has already begun to mail out refunds to those who filed in January. And if those consumers spend the bulk of their refunds quickly, the April and May retail sales data could show a big pop.

Or maybe not. High-income taxpayers will be writing out a bigger check to Uncle Sam. Because 641,000 of the wealthiest taxpayers chose to divide the 1993 tax hike into three installments, they will be paying an extra $4.2 billion in taxes by Apr. 17. That will decrease disposable income.

Some signs still suggest a downshift in consumer spending. In addition to growing pessimism about the future, jobless claims are rising, and higher payments for adjustable-rate mortgages are taking a bigger chunk out of budgets. These yellow lights are probably why the Fed chose a wait-and-see approach.

If spending does resurge, the central bank will likely move again at its May 23 meeting. Although the Mar. 27 resignation of Governor John P. LaWare removes a recent inflation hawk from the policy committee, the Fed probably will not sit still if recent slowdown signs prove to be only temporary.

But while consumers are flashing mixed signals about their future spending, another key sector of domestic demand, business investment, shows few signs of slowing. New orders for durable goods fell 0.8% in February, but after three strong increases.

New orders for nondefense capital goods remained at a high level (chart). They edged up 0.1% in February, after surging 10.9% in January. Industrial machinery has been particularly strong in early 1995, advancing 9.4% in January and 1.5% in February.

Shipments of capital goods also have been robust, indicating that business investment was a solid contributor to first-quarter GDP growth. Although some equipment is being exported, the gain shows that companies are spending big on productivity-enhancing machinery, especially computers.

The Fed is unlikely to clamp down on signs of strong business spending because such outlays cut labor costs, ultimately easing price pressures. But consumers are likely to feel a bigger squeeze from tighter monetary policy. And since a home is the biggest purchase a family makes, the housing sector and all of the related spending may have to suffer even more before the Fed is ready to stop tightening.

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