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

The U.S. economy has been posting above-trend growth in real GDP since mid-2003 (first-quarter growth now stands at 3.9% and the second quarter figures to be in that range). This growth pattern, in turn, has been generating systematic increases in payroll employment since the cyclical low last August, and job growth has been quite good in recent months.

The sustained pickup in economic growth and job creation is putting persistent upward pressure on both labor compensation and core inflation (excluding prices of food and energy). Indeed, we’re now faced with an issue typical of most economic expansions in the past, i.e., rising inflation that could take a serious toll on the economy over time.

Most inflation measures have been picking up since late 2003, and recent news has added to inflation concerns. Recent revisions to the first-quarter GDP accounts raised most inflation readings in the accounts and reinforced other evidence of a broad-based upturn in core inflation. The core Consumer Price Index rose at a year-over-year rate of 1.7% in May, and the core price index for personal consumption expenditures (a favorite of the Greenspan Fed) rose at a 1.6% pace in both April and May. While these inflation rates still are low by most historical standards, the patterns of increase are perfectly clear.

Housing demand surges in anticipation of rising interest rates …

The emerging inflation picture and strengthening prospects for action by our central bank to limit the inflation process have put significant upward pressure on long-term interest rates since March. These rates still are historically low, however, and the evolving upswing in job creation and income growth certainly has been supporting housing demand. Furthermore, the broad-based perception in financial markets and the real estate community that interest rates are likely to move higher beyond mid-year apparently has spurred home buying substantially.

Sales of both new and existing homes easily hit new records in May, totaling a mind-boggling 8.17 million units, and the second quarter is sure to set records as well. The strength of demand also is evident in the prices of homes sold; indeed, the median price of existing homes sold in May was 10.3% above a year earlier. And NAHB surveys of single-family builders, as well as surveys of mortgage lenders conducted by the Mortgage Bankers Association, show that the demand for homes remained robust in June.

Consumer confidence/sentiment shift up as job markets improve …

Measures of consumer confidence (Conference Board series) and consumer sentiment (University of Michigan) both moved up nicely in June. Consumer assessments of both current economic conditions and the near-term economic outlook have been on the upswing for several months.

The marked improvement in the job market presumably has been the major factor behind the upswing in consumer attitudes. It’s also likely that the ongoing increases in house values have buoyed the mood of consumers; after all, a record proportion of America’s households own their own homes (68.6% in the first quarter ). Finally, a retreat in energy prices, albeit modest, probably had a positive impact on consumer attitudes in June.

The Fed starts moving toward monetary neutrality at a ‘measured’ pace …

As widely expected, the Federal Reserve hiked short-term interest rates at the conclusion of the meeting of the Federal Open Market Committee (FOMC) on June 30, raising the federal funds rate target from 1% to 1.25%. This was the first rate increase since May 16, 2000 when an inflation-wary Fed moved the funds rate up to 6.5%.

The June 30 rate increase is only the first step in what is likely to be a persistent march by the Fed back to a position of monetary “neutrality” — where monetary policy neither stimulates nor impedes growth of the economy. Neutrality probably involves a real (inflation-adjusted) funds rate of 2%-2.5%, and that will mean a nominal rate of at least 4%.

The June 30 FOMC statement described the upside and downside risks to both economic growth and price stability as “roughly equal” for the next few quarters and suggested that some of the recent pickup in inflation was associated with “transitory factors.” The statement also stressed that the new monetary policy position still is “accommodative.” There was no firm commitment regarding the speed of adjustment back to monetary neutrality, although the statement once again referred to “a pace that is likely to be measured.”

Despite the rather “dovish" tone to the FOMC statement, the markets seem to be expecting quarter-point hikes at most FOMC meetings between now and the end of 2005. NAHB’s forecast is broadly consistent with this view, showing the funds rate at 2% and 4% at the ends of 2004 and 2005, respectively.

Further increases in long-term interest rates should be moderate …

Unlike some past periods (like 1994), the Fed has given a lot of advance notice about its monetary policy intentions. As a result, long-term interest rates moved up by nearly a percentage point in advance of the June 30 FOMC meeting, and the upward adjustment to the federal funds rate (and the FOMC statement) seemed to have little net effect on the bond and mortgage markets.

The process of monetary tightening that lies ahead presumably will involve some further upward pressure on long-term interest rates even though the monetary policy process has been widely anticipated. After all, monetary tightening is implemented by withdrawing liquidity from the financial system at the same time that an expanding economy is generating stronger credit demands.

While further increases in long-term rates are inevitable, these increases will be moderate as long as the Fed is able to keep a lid on core inflation with the monetary policy process we are anticipating. NAHB’s forecast currently shows increases of about 125 basis points in long-term rates between mid-2004 and late 2005, less than half the projected increase in the federal funds rate.

The housing sector will come off recent highs but maintain near-record levels of activity …

The robust second-quarter rates of home sales and single-family housing starts, and the strong rate of acceleration in house prices, are not likely to be sustainable. However, the economic and financial market environment should continue to be friendly to housing. Furthermore, the supply-demand balance in the single-family market currently is excellent and inventories are quite low, paving the way for the future.

NAHB’s forecast currently shows declines of roughly 10% in single-family starts and home sales over the next year and a half. This pattern still shows records for sales and starts for 2004 as a whole, reflecting the extremely strong first half of the year. It’s also noteworthy that our projection for total new housing units in 2005 (including multifamily structures and manufactured homes) is close to 2 million units, consistent with NAHB’s recent long-term forecast of average annual production rates for the 2004-2013 period.

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