Housing market, Fed policy, deficit spur debate over economy in ’07

After four years of robust growth, the U.S. economy has decelerated sharply — from 5.6 percent annualized growth in the gross domestic product in the first quarter to a 2.2 percent pace during the third quarter. There is considerable debate over the pace and direction of growth in 2007.

Housing is key

The direction of the U.S. economy in 2007 will be heavily influenced by the housing sector. Although housing only accounts for about 5 percent of GDP, it has been responsible for up to 75 percent of all U.S. job growth in the past four years. Employment has surged in residential construction with a sharp increase in the number of mortgage lenders and real estate appraisers.

During boom phases, U.S. housing starts tend to peak at about 2.0 or 2.2 million starts, and by 2005 and early 2006 housing starts were at this level. An analysis of the five major U.S. housing market corrections since 1970 shows that when the housing market turns down, it tends to fall roughly in half — to about 1 million starts. On average these five U.S. housing down cycles lasted about 18 months.

Current account deficit

The current account deficit was $792 billion in 2005 and is likely to hit nearly 900 billion dollars in 2006 — just under 7 percent of GDP. There are two natural channels for correction of such a large deficit: an economic slowdown that would cool demand for imports and a dollar depreciation that would make imports more expensive and exports cheaper. It is likely that both forces will be in play in 2007. Slower U.S. growth in conjunction with an economic pickup in Western Europe and Japan should help to provide a shift of momentum on trade volumes.

Meanwhile, the dollar has recently depreciated sharply as doubts about the strength of the U.S. economy spread. A decline of the dollar to 1.40 or even 1.50 versus the euro seems likely in 2007 if the housing slowdown continues. Most studies of the relationship between the dollar and the trade balance suggest that a 10 percent depreciation of the dollar can be expected to reduce the trade gap by about 1 percent of GDP. With a dollar that is 15 percent lower in 2007 than in 2006, a slower rate of growth, and moderately lower oil prices, the current account deficit could decline to roughly 5 percent of GDP by late 2007." read more

By Oxford Analytica