The Mean Reversion of US Residential Investment

Making the case for a recovery in US housing used to be pretty lonely. As the data steadily builds, the question has now shifted to how far the recovery can go. As impressive as the turn in residential investment has been, when viewed over the longer term it is just getting started.

Household formation surged in the decade after World War II, as soldiers returned home and the boomers were born. In those post-war years, housing’s share of real GDP averaged 7.4%. After 1960, housing’s share settled into a lower equilibrium and has since averaged 5.6%, a more conservative reference point for assessing where the housing market could be heading today.

During the recent boom, residential investment’s share of GDP peaked at 6.2% in 2005 and then began a lengthy and painful descent. Housing contracted for a record 14 straight quarters, on average slicing a full percentage point from the economy’s annualized growth rate. By the time the housing sector finally hit bottom in early 2011, its share of GDP had been cut by more than half to just 2.4%.

Housing cycles tend to be symmetrical: the steepness of the decline is typically mirrored by the slope of the recovery, a pattern that economists call the “Zarnowitz Rule,” after the pioneering business-cycle economist Victor Zarnowitz. The recent housing downturn was particularly fierce and, now that the recovery is here, the upturn could be equally robust.

Projecting out a recovery over the same time frame as the bust, housing could approach its average share of GDP sometime in the next three years or so. Residential investment has already been adding about a quarter of a percentage point to annualized GDP growth over the past six quarters. As the housing recovery gains steam, residential investment could directly contribute up to a percentage point to the economy’s growth rate.

Some sectors of the economy are already picking up strength, from homebuilders to mortgage financing. A few industries shut down so much of their production during the bust that they are having a hard time keeping up with the recovery: building materials such as plywood and drywall are reportedly in short supply.

In past business cycles, residential investment was typically an early mover, as homebuilders took advantage of low interest rates for new construction before the Fed tightened rates. In this cycle, housing is arriving late, pent-up demand is high, and the Fed says interest rates will stay low through 2015. The mean reversion of residential investment could propel the economy’s growth well into the late stages of this cycle.

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