The Home Buyer's Korner

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October 24th, 2014

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Why Housing Remains Sluggish

sluggish housingRecent rounds of labor market data add to an emerging puzzle whose resolution will be central to the future the housing recovery.  Over the past few weeks we have learned that employment is growing at a healthy clip, with 248,000 jobs created in September, and an average of 220,000 jobs created each month over the past year.

Moreover, unemployment has fallen both further and faster than most had anticipated. The latest reading suggests that unemployment is down to 5.9 percent, and has fallen about a full percentage point in each of the past three years. These are all symptoms of a healthy economic expansion and should have a profound effect on housing.

When workers feel good about their jobs it leads to faster wage growth; consequently workers think about moving into large homes and would be home buyers feel ready to take on the responsibility of home ownership.

Yet average hourly wages in the private sector remained flat for September (they fell by a penny), and they’ve grown at a rate of only around 2 percent over the past year.

Historically, low unemployment led to faster wage growth and home purchasing, but that relationship appears to have broken down since the Great Recession.

The recent data has made a sharp departure from the usual textbook analysis in which a tighter labor market leads to faster wage growth, and subsequent a robust housing market.

Oddly, as the great recession threw millions of people out of work, wage growth barely slowed despite the textbook prediction to the contrary. Then through the ensuing recovery, unemployment fell rapidly, but as Wall Street found its footing wage growth has barely moved and the main culprit in a lack luster of New Home Sales reports for 2014.

By the usual analysis, the key variable is how much “slack” there is in the labor market. When unemployment gets too low — toward what economists call the “natural rate” (don’t be fooled, there’s nothing natural about it) — there’s no more slack, and inflationary pressures start to build. This is the key reason the Federal Reserve has historically been nervous about keeping its foot pressed on the accelerator when unemployment got this low.

The problem is that economists don’t actually know how much slack there is in the economy, because we don’t know what unemployment rate the economy can sustain without sparking inflationary pressures. The Fed’s current guess is that the natural rate is around 5.25 to 5.50 percent and we are currently at 5.90 percent.  This is just a guess based on historical patterns, but it’s a critically important one.  While unemployment’s not yet that low, the current trajectory puts us there soon and shortly after see a real uptick in the housing sector. Additionally it’s the key reason the Federal Reserve policy makers have been talking about raising interest rates prior to concerns of economic slowdown outside the country.

Given how starkly the latest episode has deviated from historical patterns, the wisdom of relying on past patterns repeating themselves seems questionable.

The lack of any wage pressure right now stands starkly at odds with the view that the economy is about to run out of slack. Two explanations spring to mind. Perhaps the unemployment rate is giving us a false signal, and there are millions more workers waiting to return to the labor market than suggested by the official statistics. That is, the jobless will return when the jobs return. Or perhaps the natural rate is really much lower than most economists estimate. After all, at the end of the Clinton administration, unemployment was below 4 percent, while inflation remained low and stable.

Rather than guessing whether the labor market has run out of slack, why not look for more direct evidence? Perhaps we should be using current rates of wage growth to infer whether the economy is nearly out of slack. By this view, the expansion has still got quite a way to run.

To get a sense for this, realize that businesses will feel the need to start raising prices faster only if wage growth starts to exceed the rate of inflation, plus the rate of productivity growth. Given that the Fed is targeting inflation of 2 percent, and productivity typically grows at 1 to 2 percent, this suggests we should infer that the economy is about out of slack only when wage growth hits 3 to 4 percent and ultimately a rebound in housing.

The fact that the labor market isn’t delivering wage growth anywhere near this danger zone suggests that there remains a lot of slack left in the economy.

While many workers are no doubt frustrated that they’re not seeing wage gains, there’s a sunnier implication in all this for the jobless. Subdued wage growth is telling policy makers it would be premature to hang the “mission accomplished” banner above this recovery. We can do a lot better than an economy in which 9.3 million people remaining unemployed and dampening the housing recovery.


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