For most of 2006, our forecast for the California economy has been that the slowing housing markets would be a drag on growth – enough to slow the overall economy, but not enough to create a recession. While both building permits and construction employment have fallen faster than we predicted earlier in the year, other sectors have fared a little better than we expected, leaving the California economy as a whole growing slower than it has been, but slightly faster than we predicted.
So far, so good – but the end of the story is still in doubt. In our thinking, the outcome has always hinged on whether some other source of weakness would emerge to create a double whammy that would tip California into recession. With this in mind, this installment of the California Report looks at three California issues that we’ll be watching closely in 2007. Two of these are potential candidates for that second source of weakness, and the last examines whether there are any “savior sectors” that will soften the impact of the real estate slowdown.
In the second half of 2006, the East Bay remained the fastest growing economy in the Bay Area, with a year-over-year rate of job creation well above the state average during this period. However, the local economy showed some slight signs of slowing in the second half of the year, as the surprisingly resilient East Bay real estate market finally showed signs of fatigue.
Just about everyone agrees that rapid appreciation of home prices played a major role in keeping consumption spending afloat in the wake of the 2001 recession, either directly through equity withdrawals or indirectly through the increased feeling of wealth derived from earning a 20% rate of return on your biggest asset. However, there is much less agreement on what happens to consumption now that home price appreciation has stopped: does it fall by a little or a lot, and how fast does this transition occur? Most of the ambiguity comes from an academic debate about whether consumers treat an increase in housing wealth differently than an increase in other types of wealth. A rough estimate of the wealth effect from financial assets is that an increase in wealth of $100 will increase annual consumption by around $4.
However, several recent academic studies suggest that that a $100 increase in housing wealth could increase consumption by as much as $12 per year. These estimates imply that 15% appreciation on a $400,000 home could have added as much as $7200 to annual consumption spending. Growth slowed a little bit in 2005, but it is hard to distinguish the 2005 slowdown from the larger slowing trend that has prevailed since 2000. Thus, a middle-of-the-road interpretation of the British evidence suggests that while slowing appreciation may have had a small effect on consumption growth, it certainly wasn’t enough to sink the overall economy.
U.K. Growth in Final Consumption Spending (left, Seasonally Adjusted Annual Rate) and U.K. Mortgage Equity Withdrawals (right, mil. ₤, Seasonally Adjusted)
