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Eye on the Economy
By David F. Seiders, NAHB Chief Economist

An extended process of disinflation in the U.S. economy (positive but falling inflation rates) has driven key measures of core inflation (excluding food and energy) dangerously close to zero, threatening slippage into a highly destructive deflationary spiral (á la Japan). The most recent readings for the Producer Price Index (PPI) and the Consumer Price Index (CPI) still show very low inflation but suggest that disinflation may have run its course. Indeed, the core CPI picked up a bit in February, showing a 1.2% increase from a year earlier.

While core inflation may be stabilizing, it’s much too early to worry about accelerating inflation in the U.S. economy. The weakening dollar is causing prices of imported goods and services to firm up (in dollar terms), but that’s not a big deal for our inflation picture as yet. Furthermore, falling unit labor costs in the U.S. business sector continue to put downward pressure on pricing in U.S. markets. That pressure will be with us for some time as growth in labor productivity progresses and corporate America continues to cut labor costs to boost profit margins.

The Fed holds monetary policy steady and signals a lot more ‘patience’ …

The Fed held monetary policy steady at the March 16 meeting of the Federal Open Market Committee (FOMC), as the FOMC voted unanimously to keep the federal funds rate target at 1%. The assessments of upside and downside risks to sustainable growth (balanced) and to inflation (biased slightly to the downside) remained the same, leading the FOMC to retain the key policy signal first issued at the January 28 meeting: “With inflation quite low and resource use slack, the committee believes that it can be patient in removing its policy accommodation.”

While the “patient” signal was reassuring to financial markets, it remains to be seen how patient the Fed will be as the year moves along. Other parts of the FOMC statement actually suggest a lot more patience: On the inflation front, the FOMC repeated a statement first used last December: “Increases in core consumer prices are muted and expected to remain low.” With respect to the labor market, the FOMC said: “Although job losses have slowed, new hiring has lagged.” That’s a less enthusiastic assessment of the job market than at either the December 9 or the January 28 meetings.

Incoming data on inflation and the labor market, along with the tone of the March 16 FOMC statement, have encouraged NAHB to push back the first projected rate hike by the Fed to January 2005 (rather than November 2004). Projected levels of long-term rates also have been trimmed (see below).

Sagging long-term rates give housing yet another boost …

Long-term interest rates fell to cyclical lows last June when the Fed dropped the federal funds rate to 1% in an environment of slow economic growth, rising unemployment and falling inflation. Long rates then moved up in the second half of 2003 as economic growth surged and the unemployment rate began to move down. But the long rates have now moved well off their late-2003 highs as economic growth apparently has slowed, labor market problems clearly have persisted, inflation has been dead in the water and the Fed has issued the “patient” theme several times.

The long-term mortgage rate fell to 5.2% last June, moved above 6% later in the year and then fell to 5.4% by the third week of March. One-year ARM rates traced a similar pattern and those rates now are about the same as they were in mid-2003 (3.4%).

All these rates are great for housing, of course, but the recent declines must be viewed as a pleasant surprise and a boon to the sector. Indeed, recent developments have prompted NAHB to temper the increases in both FRM and ARM rates in forecasts for the balance of the year. We now expect these rates to average 6.1% and 4.1%, respectively, in the fourth quarter of 2004.

Housing market momentum looks quite good so far this year …

Available housing data for early 2004 are quite good, although some measures are below the record-breaking numbers posted in the second half of 2003. Seasonal adjustment difficulties apparently held down housing starts to some degree, as weather patterns were unusually good late last year and unusually bad early this year. It’s also possible that the bounce of interest rates off their mid-2003 lows energized some “fence sitters” into buying single-family homes in late 2003 instead of waiting until 2004.

Housing starts averaged 1.89 million units (annual rate) for the January-February period, down 7% from the fourth quarter but still above the average for all of 2003. Sales of new homes averaged 1.13 million for the same period, up slightly from late last year and 4% above the 2003 average. NAHB’s Housing Market Index for March stood at 64, equivalent to the average for last year, and weekly data on applications for mortgages to buy homes have been running at least on a par with 2003.

The housing data for early 2004, along with reductions in current and projected interest rates, have prompted upward adjustments to NAHB’s housing forecasts for both 2004 and 2005. We’re now projecting a bit over 1.80 million housing starts for 2004 and 1.75 million for 2005, compared with 1.85 million in highly exuberant 2003.

The Fed is criticized for overstimulating housing demand and house prices …

The Federal Reserve is being roundly chastised in some circles for keeping interest rates too low for too long. Some pundits are criticizing the Fed for feeding house price bubbles that will burst when interest rates eventually rise. They argue that the Fed should raise rates immediately, accepting some short-term costs to the economy while avoiding a potential economic disaster down the line.

Those who fret about house price bubbles note that price appreciation has accelerated once again while mortgage rates have shifted toward their cyclical lows. There’s no question that historically low interest rates have bolstered housing demand and have contributed to upward price pressures. After all, the low rates have effectively maintained affordability as well as the competitive position of ownership over renting in most areas.

“Aye, there’s the rub,” say the bubble theorists. If interest rates have held it all together so far, rising interest rates will weaken buyer demand as well as house prices. Why not stop the upward price spiral sooner rather than later? Have the Federal Reserve pull the trigger now, they say.

But the Fed will not pull that trigger …

The Fed simply is not going to raise rates in order to weaken house prices. Furthermore, the eventual monetary tightening process will be occurring in an environment of stronger employment and household income growth, factors that will be bolstering housing demand as rising rates exert an inevitable drag. History clearly shows that house prices will not fall when these “real” economic fundamentals are strengthening.

Rates of house price appreciation are likely to recede to some degree on a national basis, but the chances for outright price declines are negligible. As the Fed snugs up monetary policy and mortgage rates firm up gradually over time, house price appreciation should gravitate toward the rate of growth of per capita personal income in places where the supply of buildable land keeps pace with housing demand. Where land-use constraints are severe, price appreciation may continue to outpace income growth even as interest rates rise.

NAHB Chief Economist David Seiders analyzes the economy from the point of view of the housing market every other week in the free e-newsletter, “Eye on the Economy.” The preceding is a reissue of his March 24 edition. To subcribe to “Eye on the Economy,” click here.

Don’t Miss NAHB’s Spring Construction Forecast Conference

See what's on the horizon for the housing industry at the semi-annual gathering of the country's premier economists and finance experts. Get the latest forecasts on housing starts, project budgets and other economic bellwethers at the Spring Construction Forecast Conference on April 21 at the National Housing Center in Washington, D.C. Visit the Web site for more information.

Want more economic information? Find it in our publications.

Find more in-depth information in our three economics publications, Home Builders Forecast, Housing Market Statistics and Housing Economics. All are availaible by subscription. 

• Home Builders Forecast includes analysis of single-family and multifamily residential activities, residential remodeling and the full range of nonresidential construction as well as the macroeconomic factors such as GDP, employment and interest rates that drive construction. If your business depends on reliable estimates of housing starts, construction spending and remodeling activity, Home Builders Forecast is designed to meet your needs.
• Housing Market Statistics contains an overview of important developments and trends that serves as an executive summary of the current industry situation. It also contains annotated charts depicting movements in key indicators and tables providing monthly, quarterly and annual data for more than 250 variables.
• Housing Economics provides a rigorous monthly overview of the economy, along with monthly data for more than 100 local markets and in-depth analyses of the niches and nuances of home building markets. Available online or in print, it is written in terms that builders, manufacturers and housing finance professionals can understand and apply to their own businesses.
  
  Housing Economics and Housing Market Statistics are also available through BuilderBooks.com for a special combination rate. 

To learn more or to order any of these three NAHB economic publications, visit the Economics Publications Information section of the NAHB Web site or call 800-223-2665.

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