Ask the Economist: Housing is Not Acting ‘Normal’

Douglas G. Duncan is Fannie Mae's SVP and Chief Economist. He is responsible for providing all forecasts and analyses on the economy, housing, and mortgage markets for Fannie Mae. Duncan also oversees corporate strategy and is responsible for strategic research regarding external factors and their potential impact on the company and the housing industry. He serves as the Chair of the Fannie Mae Corporate House Price Forecast Committee. Named one of Bloomberg/BusinessWeek's 50 Most Powerful People in Real Estate, Duncan is Fannie Mae's source for information and analyses on the external business and economic environment, the implications of changes in economic environment to the company's strategy and execution, and forecasting for housing activity, demographics, overall economic activity, and mortgage market activity. Duncan recently discussed with DS News the weak economic growth in Q1 and the progress of the housing market as far as expansion from the last recession.

The advance estimate for GDP growth in Q1 was only 0.5 percent. What does this mean for the economy in the first quarter?

Our forecast was about 0.7 growth and it came in at 0.5. People's expectations had adjusted toward that. The good news in there was that housing actually increased its contribution, and that's consistent with our forecast. The thing I think people continue to be disappointed with is the consumption numbers and the business fixed investment numbers were quite weak. That's actually not surprising, given that corporate profits have fallen over the last several months, and companies typically don't invest when profits are falling. That is a risk component of the picture going forward because there is a pretty high correlation between a decline in profits and a recession, even though most people don't have that in their forecast at the moment.

The subject of your presentation at the Five Star Government Forum in late March was "Housing Affordability Constrains as Expansion Matures." Can you expand on this theme?

Each year, we pick a theme in December and announce it in January, and then we see how well we have anticipated what is likely to be the underlying story in the economy over the successive months. It has two parts: the expansion matures part is intended to alert people to think about risk management because this is now the fourth-longest expansion since World War II and I don't believe that the business cycle has been repealed. So at some point, probably in the next two to three years, there'll be a recession, and people should be thinking about that. None of the forecast models show that. But the longest expansion we've had post-World War II is 10 years, and we're now working on the seventh year. It's just an alert to people to be thinking about risk management, and even if we don't see a recession for a while, it's okay to keep your attention on potential risks. That's one part of the story.

The other part of the story, housing affordability constrains, recognizes the fact that while some people are claiming that housing is acting normal, we don't agree with that. If you look at the supply function, it's well away from normal levels of activity. For example, a normal sales ratio of existing homes to new single-family homes is about five and a half to one. So for every one new home that is sold, five and a half existing homes are sold. In the prices, that ratio rose to well over 10 to one, and now it's only back to about eight to one, and the issue is not existing-home sales—it's new home sales. The other way of looking at it is, if you look at the relationship between the number of housing starts per thousand households in the country, the current level of housing production is only at the very low point of production from the last two recessions. So we're still a long way from normal on the supply side, and what that's doing is raising real house prices. And real house prices are raising faster than real incomes, which is creating an affordability problem for people that would like to become first-time homebuyers.

On the rental side, the same thing is going on. With the rental properties,  construction is at normal levels, but almost all the construction that is being done is class A, or the higher rent properties. Nothing is going on the class C properties, which is the lower rent properties. So when a new household forms and they move into a rental, they are going to be paying a higher share of their income than might normally be the case, which slows the pace at which they can save money to buy a house. So there's a relationship in affordability on both sides of the equation. The other piece of that is, real incomes are still growing much more slowly than the long-term average.

What all that means is, income isn't growing, the expansion is maturing, and the supply function for building lower cost homes and apartments is just not working.

Why do you think there will be a recession in two to three years when none of the other forecasts show it?

It's not actually in our forecast, we're just trying to get people to not be complacent and to think about risk management. It's not actually our forecast, but we think it's worth noting, because this expansion IS maturing.