How much more will construction fall?

So far, the only direct, significant impact of the housing downturn on the economy has been the drop in residential investment. It's certainly been a nasty fall. After representing 6.3% of GDP in the 4th quarter of 2005 (a level not seen since 1951), it stood at 4.9% of GDP in the second quarter of this year. In real terms, it has fallen 18.6% during this period.

This drop subtracted 0.3% from total GDP growth in 2006, with an additional 0.9% and 0.5% over the last two quarters. So is the bottom in sight?

Yes, according to the median forecast in the Federal Reserve's Survey of Professional Forecasters. The forecasters expect an additional 4% drop in residential investment between the second quarter and the first quarter of 2008, after which it'll start a slow recovery. That roughly implies that it'll represent, at the bottom, around 4% of GDP.

This seems a bit optimistic given recent events and historical precedent. In previous housing downturns, residential investment has bottomed at around 3.3% of GDP. In addition, housing starts are still around 1.4 million and traditionally they fall to below one million during rough times (actually, the median forecast sees this level as the bottom and sees a slow rise in 2008).

Needless to say, forecasters seem unduly optimistic on residential investment. Although they've already cut the GDP forecast for this year from 2.6% late last year to 2% currently, negative surprises seem to be, unfortunately, quite likely. (And this is not even taking into account the possible impact on consumers).