Rising family income coupled with low mortgage rates are two of the critical ingredients for a strong housing market, which are expected to be at work in 2004, according to Freddie Mac’s latest economic forecast.

The income gains are fed by fiscal and monetary policy reinforcing each other to drive real GDP growth to an expected 4.3 percent real gain in 2004, Freddie Mac predicted. Economic expansion at that rate is sufficient to gradually draw down the unemployment rate, from 5.9 percent as of November to an average of 5.5 percent during the last quarter of 2004. The job gains will drive family income gains.

This year began on a good note with the Institute for Supply Management’s release of its manufacturing survey data for December, which showed that the increase in new manufacturing orders was the best in more than 50 years, and the overall index – which combines responses on new orders, employment, production, and other factors – attained its highest reading in 20 years. The battered manufacturing sector should begin to add jobs as a result. The Institute’s non-manufacturing index remained above the “expansion” threshold for the ninth consecutive month, reinforcing the conclusion that the economy should expand at a strong pace in the first half of the year.

Inflation in consumer prices should remain low and stable in the coming year: The Consumer Price Index (CPI) is expected to rise only 1.4 percent during 2004, which would be the least inflation since 1986, reflecting excess capacity at many plants, strong productivity growth, a loose labor market, and weakening energy prices. Indeed, the “core” of the CPI (subtracting the food and energy components) was up only 1.1 percent in the year ending in November. With inflation low and in-check, the Fed has ample room to maintain the Federal Funds target at 1 percent. In fact, the Fed has stated that an accommodative monetary policy “can be maintained for a considerable period.” We believe the Fed will keep the target at 1 percent through mid-year and perhaps until the end of the year.

With the two key ingredients in place, 2004 will be another good year for housing. Slightly higher interest rates will choke off some construction and sales activity at the margin, with starts slipping 5 percent to 1.75 million dwellings and new- and existing-house sales down 3 percent to 6.98 million. But that still places construction and sales well above the level of 2002, which was regarded as an exceptional housing year at the time.

Freddie Mac expects mortgage rates will average slightly higher than 2003, somewhere around 6 percent for 30-year fixed-rate mortgages, followed by an additional increase in 2005. With mortgage rates rising ever so slightly, the demand for new homes will lessen, Freddie Mac reported.

Nonetheless, Freddie Mac predicts residential mortgage debt growth will remain quite strong (up 11 percent) in 2004, albeit slower than the past two years, for the following reasons: 1) Home values will be up about 6 percent; 2) Starts and sales, while less than in 2003, are still better than in prior years; 3) Home equity lending will continue to be brisk; and 4) Real estate remains attractive as a consumption good and investment vehicle.

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