NAHB predicts slowdown in 2006 new housing starts.

Frustrated that steadily increasing the federal funds rate in quarter-percentage-point increments hasn't driven up the long-term mortgage rates, the Federal Reserve will continue tightening into early 2006, when housing activity should start flattening out below this year's torrid levels, NAHB chief economist David Seiders told the NAHB construction forecast conference in Washington, D.C. last week.

"The housing market is seeking out a peak," Seiders said, pointing out that with housing starts increasing 3.4% in September and third-quarter performance exceeding expectations there is growing evidence that the Fed has started to hit its mark and housing will begin losing some of its exuberance in the period ahead.

The rates on 30-year fixed-rate mortgages reported weekly by Freddie Mac have been moving up over the past month and are now above 6%.

In his housing forecast, Seiders is predicting that long-term mortgage rates will rise by another 60 basis points by the third quarter of next year, bringing them to about 6.6%.

The Federal Reserve will decide to boost its federal funds rate by one-quarter of a percentage point at each of its next three meetings, he predicted, bringing it to 4.5% at the end of January when Fed chairman Alan Greenspan's term runs out. Most likely, that will be the rate at which the central bank decides that its policies have reached neutrality, neither stimulating nor slowing down the economy.

Greenspan has discovered that it's no longer as easy to slow down housing as it used to be, and the Fed has run into difficulty in taking some of the steam out of a boom that it believes has been running too hot and cannot be sustained.

The proliferation of "exotic" adjustable rate mortgages (ARMs) such as interest-only and payment-option loans, along with a rise in speculative buying, has strengthened the Fed's determination to gain control over the housing sector.

Monetary policy may already be starting to work. The Mortgage Bankers Association's weekly index of mortgage applications to buy homes has for the past 10 weeks shown "fundamental flatness hovering around a high level," Seiders said. However, initial interest rates on ARMs have remained at attractive levels despite increases in short-term market rates because lenders are discounting the initial ARM rates, "bringing the actual rate to 2% below what could be charged."

NAHB is forecasting a decline in total housing starts from 2.032 million this year to 1.94 million in 2006 and a further drop to 1.883 million in 2007. After that, the annual production of new housing units (including manufactured homes) should settle around 2 million units, which is within the 1.9 million to 2.1 million rate that is sustainable on average for the 2003-2013 period, he said.

"We have been running a tad above that," Seiders said, "but the comedown shouldn't be all that dramatic."

Single-family construction is projected by NAHB to decline from 1.683 million starts this year to 1.590 million in 2006 and 1.533 million in 2007. Multifamily output, however, should remain close to the 349,000 level expected for this year.