Probably the big news in the December 2006 Economic Outlook published by Freddie Mac's Office of the Chief Economist last Friday was that the office has finally changed its interest rate projection for the year.

The monthly forecast since late last year has clung to a projection that the 30-year mortgage rate would average 6.5 percent for the year. This number went up to 6.6 for a few months in late summer when rates did rise steadily but only now, with recent rates off of July highs by 69 basis points has Freddie revised its projection to 6.3 percent for the 4th Quarter and 6.4 percent for the year. The average rate for 2007 is projected at 6.3 percent which is a substantial improvement over the 6.7 average forecast earlier in the year.

The main thrust of the December Outlook, however, was answering two questions: "What will a housing recovery look like?" and "when will it arrive?"

Freddie Mac harkened back to history to answer these questions. The report compared the current housing downturn to earlier ones following peak growth in 1973 and 1978. In those years residential investment as a share of GDP rose to nearly 6 percent and then slid to 4 percent over the following six to eight quarters compared to a long-run average of 4.5 percent. After bottoming out, investment rose in the following four quarters. Price appreciation did not turn negative on a national basis after these booms but did show extended sluggish price gains.

During the most recent boom residential investment rose to 6.25 percent in the second half of 2005 but has been declining rapidly since then. It fell at an 18 percent annual rate (adjusted for inflation) in the third quarter and looks to do the same in the fourth quarter. This would reduce residential investment relative to GDP to 4.5 percent - in line with earlier referenced declines and over a similar six-to-eight quarter time frame.

However, should the 18 percent annualized decline continue through the end of 2008 the drop in residential investment would be 50 percent greater than what occurred during the 2003-2004 recession and send the investment/GDP relationship to 3 percent.

The Office of the Chief Economist, however, does not foresee such an outcome. It cites the rapid response of builders who have cut back housing starts as one factor contributing to falling inventories while buyer traffic seems to be on an upswing in response to declining prices and interest rates. The market, the report states, should stabilize some time during the first half of 2007.

Do not, however, expect the new market to be a return to what we have watched with fascination over the last several years. Rather, we should see more "normal" conditions starting next year; housing starts and sales will gradually pick up and then grow at a modest pace and house prices will appreciate at a rate in line with inflation although some hard-hit areas will not recover until the local economy does. "With smaller price gains and reduced opportunities to extract equity, mortgage debt will grow more slowly. In short, housing markets will move off center stage, but will resume quietly providing homes and opportunities to build a nest egg for millions of American households."

Other projections in the report include:

• Home price appreciation will slow further in the fourth quarter to 2 percent from 5.2 percent in the second quarter and 4 percent in the third. Prices should "trough" in the fourth quarter and appreciate 3.4 percent in the first half of next year.
• Refinancing will see the highest market share of the year in the current quarter, reaching 48 percent of all mortgage applications. This is forecast to continue through the first quarter of 2007 and then to moderate to 36 percent by the middle of the year. At the same time, delinquency rates recently increased to 1.7 percent, the highest level since 2003 but only marginally higher than in 2004 and 2005. The number is still well below the delinquency rates in the early 1990s.
• Adjustable rate mortgages will have a slightly higher share of the market than was thought a few months ago - 16 percent vs. 14 percent - still, the inverted yield curve (where short term rates tend to be only slight lower or even the same as long term) will make ARMs unattractive to borrowers who can afford to make the choice.