Despite many warning signals, the U.S. economy has not yet slowed down. Not at all. Over the most recent four quarters, inflation-adjusted GDP has risen 3.7%, precisely the same amount it rose over the previous four quarters. There has been no deceleration despite higher interest rates, higher inflation, and higher energy and other commodity prices.
Obviously, the old rules do not apply any longer. In the past, a one- percentage- point increase in the federal funds rate, the interest banks charge each other on overnight loans, would reduce real growth by about half a percent. Yet the recent increase in the funds rate from 1% to 5% over 23 months has not put even a minor dent in the growth rate. Yes, I realize the economy will probably grow less for the rest of 2006, but even if inflation-adjusted growth falls to a 3% annual rate -- a likely, but not foregone, conclusion -- the old rule of thumb would still be invalidated. Specifically, both capital spending and exports have been stronger than was anticipated a year ago.
Many economists, including me, thought that when the U.S. housing boom ended, so would the overall economic boom. Yet housing starts and sales are down about 20% from peak levels, and while various reports indicate housing prices are still ahead of year-earlier levels, that masks the fact prices indeed have declined over the past six months.
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In my view, this is due to changes in the monetary sector. In the past, higher interest rates were accompanied by tighter credit, and vice versa. These days, while interest rates have risen substantially, there have not yet been any restrictions on credit. As a result, borrowers are willing to pay a higher rate of interest, particularly when they know -- even though the Labor Department's Bureau of Labor Statistics does not -- that the rate of inflation has increased enough that real long-term rates are actually lower than they were a year or two ago.
So why has the decline in housing not yet reduced the real growth rate of the U.S. economy? A declining housing market can negatively affect the economy in three ways. First and most obvious, there are fewer construction workers, fewer purchases of construction materials, and reduced income for brokers. Second, home-equity extraction is reduced as prices level off and then decline, which, in turn, reduces consumer spending. Third, defaults and foreclosures increase, not only wiping out individuals who bought more house than they could afford, but many financial institutions as well. It is the third effect that will finally bring the economy down.
However, it won't happen for several years. The rash of defaults and foreclosures usually peaks about three years after interest rates rise and housing prices level off and then decline. At least that's how it's worked in the past. This current process started in 2005, suggesting that the major negative impact of a declining housing market won't hit until 2008. There will be some modest decline in real growth this year and next, but the increase in real GDP -- at least as reported by U.S. Commerce Department's Bureau of Economic Analysis -- will remain around 3%. Not until lenders are put under great pressure not to extend as many foolish loans -- similar to what happened in the early 1990s -- will the U.S. economy finally buckle.
Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla. Also see: Economic Outlook and Financial Market Outlook: Mike Evans' new blogs on the economy and stock market.