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

The Commerce Department recently lowered its estimate of second-quarter growth in real Gross Domestic Product (GDP) to only 2.8%, definitely below the trend rate of growth for the U.S. economy and a real trouble sign for the labor market around mid-year. Furthermore, private sector estimates of monthly GDP already show that growth actually turned negative in June as consumer spending weakened considerably and U.S. net exports contracted sharply.

Available data suggest a solid rebound in GDP growth for July, and we believe that renewed economic momentum will produce growth close to 4% for both the third and fourth quarters of the year. That growth pattern should be strong enough to generate a decent pattern of payroll job growth as well as some decline in the unemployment rate — developments that recently emerged in monthly employment reports.

The August employment report suggests the job market recovery is back on track …

The dismal employment reports for June and July were heavy wet blankets on the economic scene, challenging the self-sustaining nature of the economic expansion and pointing toward sub-par performance in the second half of the year. However, the employment report for August changed that picture.

The August employment report did not erase evidence of the mid-year “soft patch” in economic activity, but it did strongly suggest that the slowdown was temporary. The report revised payroll employment upward by 59,000 for the June-July period and recorded an increase of 144,000 for August. Furthermore, the unemployment rate ticked down in both July and August, falling to 5.4%. That’s nearly a percentage point below the cyclical high in June of last year.

The payroll employment gains for the past year now average 140,000 per month and the average for the last six months comes to 200,000. While this may not qualify as a robust performance, the job numbers are at least in a respectable range. In addition, the breadth of job growth has been impressive (extending across many industries), total hours worked have been supported by both job gains and increases in the length of the average workweek, and labor income recently has been supported by brisk increases in average hourly earnings as well as by the pickup in hours worked. Everything considered, the job market got back into gear in August.

The Fed’s favorite inflation measure is now behaving nicely …

The pickup in core inflation (excluding prices of food and energy) since late 2003 has been a major change in the economic environment. However, the Fed has been suggesting for several months that the acceleration probably involved some transitory factors that were likely to subside before long. Fortunately, that prognostication seems to have been on target.

The core component of the Consumer Price Index (CPI) settled down to some degree in both June and July, with particularly reassuring readings from the chain-core version that incorporates floating market-basket weights (a conceptually better approach). But the best news was provided by the core price index for personal consumption expenditures, the price measure recently adopted by the Fed’s policy committee (the Federal Open Market Committee) as its key inflation indicator.

The core Personal Consumption Expenditures (PCE) price index was dead flat from June to July and stood only 1.5% above the level a year earlier. That’s right in the middle of the 1%-2% “tolerance range” suggested by the Fed’s most recent semiannual Monetary Policy Report to the Congress.

The Fed most likely will raise short-term rates another notch on Sept. 21 …

The favorable employment report for August pretty much cleared the way for another quarter-point hike in the federal funds rate at the upcoming FOMC meeting on Sept. 21, and that adjustment still is a component of NAHB’s forecast.

Some pundits feel that the recent benign readings on core inflation will hold the Fed back on Sept. 21. However, the real (inflation-adjusted) federal funds rate still is hanging around zero, an untenable position for a responsible central bank in the midst of a gathering economic expansion. It’s also noteworthy that the pickup in average hourly earnings in the recent employment reports inevitably will feed into unit labor costs, and that’s the kind of inflationary pressure the Fed fears most.

Looking further down the line, the Fed certainly will continue to raise short-term rates as long as economic growth continues at a decent pace and slack in labor markets continues to contract in the process. Our forecast still shows the target funds rate at 2% by the end of this year and 4% by the end of 2005.

Long-term interest rates remain favorable as economic signals for Fed policy ebb and flow …

At any given time, long-term interest rates reflect market expectations of real economic growth, core inflation and Fed management of monetary policy. Long-term rates were driven down in the latter part of August by perceptions of economic weakness, benign core inflation and diminished prospects for further Fed tightening over the balance of the year. But the upbeat employment report for August (released on Sept. 3) caused a sudden reevaluation of all these factors, sending long-term bond and mortgage rates upward.

Despite this recent shift, long-term rates still are quite favorable. The 10-year Treasury yield is hanging around 4.25% and fixed-rate home mortgages are available at rates around 5.8%. These rates are likely to gravitate upward over the balance of this year and in 2005 but remain low by historical standards. NAHB’s forecast pegs the long-term mortgage rate at 6.25% by the end of this year and about 7% by late 2005.

Oil prices recede from recent highs but energy still is a wild card in the economic picture …

The mid-year soft patch in economic activity undoubtedly was related to this year’s steep increase in energy prices. Such an increase acts like a tax on U.S. residents that saps the purchasing power of households and raises costs for businesses (the benefits to U.S. oil producers is only a small offset).

Gasoline prices now are about 20 cents per gallon below their mid-year highs, and crude oil prices are down significantly from their mid-August highs. But we’re certainly not out of the woods, and the oil price outlook is highly uncertain. Indeed, concerns about long-term supply are growing rather than receding, and there are large prospective increases in demand associated with the rapidly growing economies of both China and India. As a result, prices of distant oil futures are well above their ranges of recent years.

NAHB’s forecast assumes some further reductions in prices of oil and gasoline during the next year and a half. If these reductions do not materialize, the Fed probably will alter its path back to monetary neutrality in order to keep the economic expansion going at a solid pace.

Charley and Frances were not strong enough to seriously damage the economy …

Hurricanes Charley and Frances caused a good deal of disruption in Florida and surrounding areas. The storms certainly stalled some forms of economic activity and stimulated others. The positives and negatives are likely to roughly wash out within the third quarter, with only minor negative effects on GDP and the labor market, and any net losses should be more than regained later as rebuilding proceeds.

The net impacts of Charley and Frances on U.S. home sales and housing production should be slightly negative in the third quarter and slightly positive further down the line. Impacts on building materials markets have been serious, of course, particularly for plywood, gypsum wallboard and other materials central to the rebuilding process.

House prices continue to advance aggressively, fueling charges of price ‘bubbles’ in some markets …

The Office of Federal Housing Enterprise Oversight (OFHEO) reports that average U.S. home prices increased by 9.4% in the second quarter on a year-over-year basis, the largest rate of increase since 1979. While this repeat-sales price measure contains some upward bias, there’s no doubt about ongoing aggressive house price increases in most parts of the country. Indeed, median prices of both new and existing homes sold in July climbed by about 9%, extending the pattern revealed by the OFHEO data.

The recent rates of house price increase have re-energized familiar house price bubble theorists and raised the eyebrows of some analysts who have argued against the existence of price bubbles in U.S. housing markets — including Fed Chairman Alan Greenspan. Indeed, the evolving disparity between growth rates in house prices and household incomes has raised legitimate questions about sustainability on the house price front.

NAHB’s forecast assumes that national house price appreciation will settle down to about 5% next year as the interest rate structure gravitates upward. While outright price declines should be rare in local, state or regional markets as the national economic expansion rolls on, prices certainly could flatten or recede in local markets that have posted extraordinarily rapid increases in recent times.

Home sales and housing production still look good, although recent records will be hard to sustain …

Home sales and housing starts definitely were stimulated by the various interest rate gyrations that materialized after long-term rates hit their cyclical lows last June. Indeed, home sales and single-family starts hit record highs during the second quarter, and the housing production component of GDP (residential fixed investment) grew at an annualized rate of 15% for that quarter.

Housing market activity is likely to taper off when long-term rates resume their upward trend. NAHB’s forecast shows modest slippage of home sales and housing starts in the fourth quarter, followed by further erosion in 2005. Even so, 2004 most likely will be another record year for the single-family market, and we expect 2005 to be the second highest on record. The homeownership rate should continue to attain progressively higher records throughout the forecast period, aided by strong performance from the condo component of the multifamily sector.

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 Sept. 8 edition. To subcribe to “Eye on the Economy,” click here.