Energy and food drive consumer and producer prices upward.  The Bureau of Labor Statistics reported that the Consumer Price Index for All Urban Consumers (CPI-U) increased 1.1 percent in June (seasonally adjusted),  the highest monthly change since September 2005.  The core CPI, which excludes food and energy prices rose 0.3 percent.  Over the three months ending in June, the CPI has risen at a compound annual rate of 7.9 percent, while the core CPI increased at a 2.5 percent rate.  The Producer Price Index for Finished Goods (PPI) -- which measures the prices of goods and services marketed by U.S. producers — also reflected the impact of commodity prices.  In June the PPI rose by 1.8 percent, and the PPI less energy and food rose 0.2 percent.

Single-family home construction drops 5.3 percent. The Census Bureau reported that the pace of single-family home construction declined by 5.3 percent in June (seasonally adjusted annual rate), though overall housing starts increased by over 9 percent.  The Census Bureau noted that changes to New York’s construction code caused an abnormal spike in multi-unit construction in June, overshadowing continued weakness in residential building sector.  Single family starts are at their lowest level in 17 years and total home starts are now 53 percent below their January 2006 peak.  (See Chart)

Industrial production off for the quarter.  Industrial production rose 0.5 percent in June, but second quarter production was down 3.1 percent from the first quarter (seasonally adjusted annual rate), according to the Federal Reserve.  The manufacturing sector did worse than industry as a whole; output was up 0.2 percent in June, but second quarter output was down 3.7 percent compared to the first quarter.

As housing prices have declined from their peak in 2006, the economic ripples have widened.  When house price appreciation slowed and then turned negative, it became obvious that subprime borrowers would not be able to refinance their way out of unsustainable mortgages.  It was clear that many households would face foreclosure and direct and indirect holders of subprime mortgage debt would face losses.  Several mortgage lenders specializing in subprime loans went bankrupt, commercial banks have been forced to raise additional capital to cover their losses, and Bear Stearns -- an investment bank with significant exposure to subprime loans -- failed.

Other financial intermediaries have been affected as well.  The actions by the Federal Reserve and the Treasury to support Fannie Mae and Freddie Mac -- a major topic at two congressional hearings last week -- were made necessary in significant measure by house price declines.  As prices have fallen and the economy has slowed, mortgage default rates have increased.  This has raised questions about the ability of Fannie and Freddie to handle potential losses from their own capital.  And so policy makers are being asked to find ways to stabilize these institutions to preserve their central role in the mortgage market.

There have been other, less obvious effects on homeowners.  Houses are durable consumer goods, but they are also part of household wealth.  Homeowners routinely draw on the equity in their houses in a variety of ways: they can sell their house outright, refinance a mortgage, or borrow against their asset by taking out a home equity loan.

The cash available after paying off mortgage debt and closing costs – the “free cash flow” that has been generated by these three forms of equity extraction -- has been substantial.  Alan Greenspan and James Kennedy have estimated that during 1991-2005, free cash flow averaged about $530 billion per year.  Of course much of this free cash went to purchase new homes.  But a substantial part was allocated to pay for consumer debt or current consumption: each year an average of $60 billion in home equity loans were repaid, an average of about $50 billion in non-mortgage consumer debt was repaid, and about $66 billion of went to pay for personal consumption expenditures.

Adding together the repayment of consumer debt and the direct financing of consumption, Greenspan and Kennedy estimate that equity extraction financed 1.1 percent of personal consumption expenditures during 1991-2000, and close to 3 percent of personal consumption during 2001-2005. 

Updated estimates show that this consumption finance ratio peaked at 4.1 percent in the second quarter of 2006 and has since declined along with house prices.  (See Snapshot)  This correlation is hardly surprising.  As house prices fall, so does home equity.  And as mortgages become more difficult and expensive to obtain in a distressed mortgage market, the extraction of existing equity becomes less attractive.

This is not good news for an economy in which employment is declining and output growth is very low.  Consumption expenditure makes up more than 60 percent of overall demand in the economy and factors that erode consumption will have a negative effect on employment and output.