Housing—Recession, Regional Impact, Potential Recovery

The housing and forest products industries have been severely depressed during the past two years as the U.S. economy plunged into major recession. This is not unusual. Rather, housing and related industries have been hit hard in each economic recession since World War II.

However, the current housing recession may be unique in its severity, in large part because both nominal and, especially, real interest rates (the nominal rate less the current inflation rate) have moved to unusually high levels. Very optimistic forecasts of housing start levels for the 1980s are being rejected and replaced with substantially lower forecasts, and the revised outlook is for a much lower domestic demand for wood building materials and, therefore, for a stagnating level of domestic demand for solid wood products through the decade.

What happened to housing?

The origins of the current difficulties in housing go back at least to the mid-1960s, when prices began a marked and accelerating rise. As the rate of inflation rose, real interest rates declined—often to zero or negative levels—and nominal interest rates slowly began to rise. In retrospect, most analysts attribute this rise to the gradual incorporation of an inflation premium into the interest rate. But expectations of the course of future inflation were not well developed at the time and, more important, the Federal Reserve Board's policy of controlling nominal interest rates precluded fully incorporating the inflation premium into the interest rates.

In October 1979 the Federal Reserve Board (Fed) switched signals. Casting aside its former policy of controlling interest rates, the Fed now aimed to control inflation by controlling the money supply. With this focus, interest rates were allowed to rise to fully incorporate the inflation premium, and nominal interest rates began to adjust upward to create real interest rates that were positive and near the long-run levels of 3 to 4 percent. Given the lags in the effect of monetary policy on the economy, the Fed's tight monetary policy gradually has affected the level of economic activity and, more recently, prices as well. While the rate of inflation has declined dramatically, nominal interest rates have dropped only modestly. The result is that real interest rates have jumped all the way from the negative levels common during the 1970s to levels that approach double digits. Both are highly unusual.

Overoptimistic forecasts

High real interest rates and other expenditure-depressing effects of the recession combined to reduce housing starts in early 1982 to annual rates of under 1 million. This is well below any of the forecasts made as recently as two years ago, including the U.S. Forest Service forecast of a 2.6 million housing start average for the 1980s.

The forecasts were made for normal economic times and recessions by definition are abnormal. Still, a growing body of informed opinion holds that the levels of housing starts forecast for the 1980s were far too optimistic even had there been no recession and had interest rates been closer to their long-term levels. This view is based in part on the belief that changing lifestyles are not consistent with the assumptions of the housing forecasts.

Less speculatively, and probably more importantly, the forecasts were too high because of special characteristics of the 1970s that are unlikely to be repeated. Specifically, during a period of rising inflation and low, sometimes negative, real interest rates, housing is one of the few hedges against inflation for the average citizen. Housing during the 1970s was an unusually good investment because it appreciated at least as rapidly as the rate of inflation; the investment could be made with a relatively small down payment, thus affording substantial "leverage;" the real interest rate was negative, so credit costs were small or nonexistent; and rising inflation afforded a substantial measure of debt relief, since the real value of the debt obligation was declining. Yet forecasters typically looked for correlations between housing starts and such explanatory variables as household formations and Gross National Product per household and generally neglected to adjust adequately for unique investment conditions that characterize the 1970s. Hence forecasts for the 1980s tended to systematically overestimate the level of housing starts.

Granted that 1982 is not normal—high interest rates and the recession clearly have depressed current housing starts—what might we expect when normal times return? Post-recession normality might be of two types: We could see a return of the high levels of inflation that characterized the 1970s, or we could have an economy in which inflation abates, but in either case we are unlikely to encounter zero or negative real interest rates. The 1979 change in Fed policy, together with the financial market's sensitivity to inflation, all but guarantee that the market will incorporate any reasonable expectation of inflation into the interest rate. Moreover, if inflation occurs, the market is likely to overcompensate, preferring to err on the side of expecting higher inflation rates than might actually happen; hurt by past inflation, lenders are likely to protect themselves by anticipating more, rather than less, inflation. If inflation abates, nominal interest rates should adjust downward once markets are confident that inflation has been controlled.

But since nominal rates are highly unlikely to adjust below levels consistent with long-run experience, it is difficult to conceive of a circumstance under which real rates again would drop to zero and negative levels.

Forest products industry—Down ...

In the postrecession economy of the middle and late 1980s, be it characterized by stable price levels or by renewed inflation, real interest rates will be substantially above those of the 1970s, and housing starts will be significantly lower than so recently was commonly forecast.

The clear implication is that the domestic demand for forest products, and particularly building materials, will be substantially below the levels anticipated by the industry in the late 1970s. That the industry as a whole generally anticipated very buoyant markets this decade is clearly reflected by its behavior in the late 1970s. For example, the bidding of Forest Service timber sales contracts to prices that simply are untenable in current and probable markets, particularly in the Pacific Northwest, illustrates the industry's overassessment of the level of future demand and prices. As a result, the industry finds itself suffering from overcapacity not only for the duration of this recession, but also for the more normal times anticipated for later in the 1980s. In the absence of supplementary markets, the 1980s almost certainly will be a period of stagnation for the forest products industry.

But not out. . .

Fortunately, this dismal prognosis may never become reality because of an excellent opportunity to penetrate major international markets.

Since World War II, the United States and Canada have slowly but steadily emerged as major world suppliers of wood and wood fiber, in terms both of value and volume. Indeed, by the mid-1970s, North America accounted for about 75 percent of the value of forest products that are traded between major continental markets and easily was the principal international wood source. Canada figures prominently in this trade, but the United States has been expanding its net export of forest products, and the overall trend suggests underlying economic forces moving toward an improved competitive position for the United States as an exporter. Indeed, the 1980s could see a major expansion of the U.S. share of world wood and fiber markets. The gloomy domestic projections provide two key prerequisites—excess capacity, both in harvesting and processing, and a low level of domestic demand that frees timber resources for possible use in foreign markets. In fact, the United States appears to be well situated to take advantage of opportunities that may develop in foreign markets during the remainder of the decade.

Two cautions: the world economy is somewhat depressed and hence demand for forest products is adversely affected, and the U.S. dollar has substantially appreciated in international markets over the past two years, thereby making U.S. exports, including forest products, expensive and discouraging foreign buyers.

But both of these situations may be rectified soon. International recessions, like domestic ones, tend to be cyclical and signs point to an ebb in the global recession. If worldwide economic recovery happens soon, the market for forest products should expand significantly.

On the second point, it is widely held that the appreciation of the dollar reflects the very high U.S. real interest rates: foreign capital has been attracted to the United States, and this has caused the dollar to appreciate. For reasons listed above, however, we might expect real interest rates to decline, which will reduce the rate of capital flow into the United States and lead to a corresponding depreciation of the dollar. A depreciated dollar would make the entire menu of U.S. goods less expensive in foreign markets and provide substantial impetus to U.S. exports. Thus, my cautious but reasonable guess is that conditions in the mid- and late-1980s could offer a great opportunity for the industry to offset some of the decline in the domestic market by expansion into international markets.

Regional implications

The Pacific Northwest and the South together account for almost 80 percent of U.S. sawtimber production. However, the importance of forest and wood processing in the economies of Pacific Northwest states is much larger than it is for the wood-producing states of the South. For example, in 1977 the lumber and wood products sectors of Washington, Oregon, and Idaho generated 17.2 percent, 38.7 percent, and 32.9 percent, respectively, of total state value added. By contrast, this sector accounted for just 9.2 percent and 3.8 percent of the value added of Mississippi and Virginia, the two southern states with the highest percentage lumber and wood value added. Any national downturn in housing starts clearly has a disproportionate impact on the Pacific Northwest and secondarily on the South, with other U.S. regions much less seriously affected.

On the other hand, the regions hit hardest by a downturn will reap the primary benefits should the international market for U.S. solid wood exports improve. In either event, the regional impact is likely to vary, caused not only by the greater dependence of the Pacific Northwest on the wood industry but also by the different importance of wood exports for the two regions.

An interesting relationship exists between the Pacific Northwest and the South. While the South has gradually been enlarging its share of the U.S. market—principally at the expense of the Pacific Northwest—the latter region increasingly has looked offshore for its markets. Given the extent to which the Pacific Northwest's regional economy relies on the lumber and wood products industry and its established position as an international trader of solid wood products, the region should benefit handsomely from an improved export outlook.

This trend suggests that one might expect the Pacific Northwest to be the major region involved in the expansion of its exports, at least initially, if for no other reason than that it is already a major international exporter of forest products. However, excess capacity at home and a buoyant international market also could attract the South. The location of southern forests vis-a-vis the European market could prove a profitable supplement to the depressed domestic market.

The rising tide that lifts all boats already is a cliché, and a discredited one to boot in the eyes of many. Nevertheless, a rising tide of U.S. exports of forest products could well boost the industry out of the doldrums and help lift two disproportionately depressed regions out of the economic swamps in which they now at mired. The conditions under which this might happen by no means are assured, but, as global recovery proceeds by fits and starts, the tide is beginning to swell.