Meet the Author

Michael Shenk |

Research Assistant

Michael Shenk

Michael Shenk was formerly a research assistant in the Research Department of the Federal Reserve Bank of Cleveland. His work focused on international topics and housing-market indicators.

10.03.07

Economic Trends

Who Cares about the Housing Market?

Michael Shenk

This month’s bounty of housing data was once again overwhelmingly negative. Both the new and the existing homes series have been falling steadily for the better part of two years. However, the economy has chugged along at a fairly decent pace throughout the downturn in the housing market. This might lead some to wonder why we care so much about housing in the first place.

The housing market is important to the economy for a number of reasons. Most directly, sales of new homes, as well as additions and improvements on existing homes, contribute directly to GDP. Spending on these two categories is factored into GDP as residential investment, and it generally accounts for just under 5.0 percent of total GDP. For the past six quarters, spending on residential investment has been falling and has lowered GDP growth on average by 0.8 percentage point. (Sales of existing homes only affect GDP directly through the commissions that Realtors make from their sale.)

The market for existing homes is important to the economy in a more indirect sense. For many Americans, their home is their largest and most valuable asset; on average, homes account for approximately 30 percent of households’ total assets. Because homes constitute such a large portion of household wealth, price changes in homes can have a significant wealth effect. When home prices are appreciating rapidly, homeowners are essentially becoming wealthier. If homeowners perceive the increase in wealth to be permanent rather than transitory, they will adjust their consumption upward. While the new-found wealth is not liquid, homeowners can still boost their consumption by borrowing against their homes, often through home equity loans. Likewise, in times of depreciating home prices, may see a decrease in wealth. A negative wealth effect can spill over into a household’s consumption pattern, either by forcing people to increase their savings or by decreasing the amount of equity they have to borrow against. Over the past few quarters, consumption has slowed slightly but remains near its recent trend, and many forecasters are expecting a rebound in the coming quarters. The persistence of consumption likely points to a general opinion that slower home-price appreciation is a transitory phenomenon rather than a permanent change in trend. However, the longer the period of slow or negative price appreciation continues, the more likely we are to see negative wealth effects impact consumption decisions.