Fed may slash rates to save the economy

SHARE

"Apocalyptic."

That's how a Wall Street economist described to me the attitudes of south Florida homebuilders to whom he recently gave a speech. The economist might have gotten a similar earful had he chatted with homebuilders in the Northeast or California. Same dreadful story in all the formerly hot markets. But how much will a housing slump infect the rest of the economy? One look at the severely inverted yield curve–often a predictor of coming recessions–sure hints at coming nastiness (though the elevating stock market tells a different tale).

One way to take a bite at the question is by looking at other countries and seeing what happened to their economies after housing bubbles burst. That's exactly what the econ team at Goldman Sachs has done. In particular, Goldman tried to figure out whether the deflating housing bubble in the United States will prompt the Federal Reserve to start cutting interest rates. So analysts looked at booms-gone-bust in Australia and the United Kingdom.

Both nations saw housing price appreciation slow from around 20 percent in 2003 to flat in 2005. And prices did actually decline in the pricier parts of England, such as in the southeast. But neither economy slid into recession, though growth did slow by about half. The Bank of England responded by cutting interest rates by 25 basis points in August 2005 but reversed the cut a year later. The Reserve Bank of Australia didn't cut at all.

OK, that's them. How about us? Goldman thinks three key differences will mean the U.S. economy won't get off so easy.

– The United Kingdom and Australia economies benefited from a strong global economy that helped mitigate the negative effects of their slowing housing markets. But the United States is a much bigger chunk of the global economy; thus global growth can't help as much.

– While residential investment in the United Kingdom and Australia didn't suffer much of a drop-off, if any, residential real estate investment in the United States is already down 15 percent from the peak. "This implies that the direct effect of housing on real GDP growth is much more adverse in the U.S., with a contribution of minus-1 percentage point [annualized] or more in the second half of 2006," Goldman says.

– Housing prices are doing worse here. As of August, the median price of existing homes was down 1.7 percent year over year. Goldman thinks prices might fall 3 percent next year. Prices in the United Kingdom and Australia never suffered an outright decline at all.

After crunching the numbers, Goldman predicts the Fed will cut rates by a whopping 1.25 percentage points next year–definitely a minority opinion on Wall Street, keep in mind–to keep the economy healthy. For 2007, Goldman is looking for 2.3 percent GDP growth.