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The labor market continues to improve despite some mixed signals in October …
The employment report for October substantially altered the labor market picture. Payroll employment was revised up significantly for the August-September period and job growth for October was a resounding 337,000. It’s clear that hurricane effects held down September (even after revision) and then boosted October, but the trend in job growth now looks much better than before the elections.
On a year-over-year basis, payroll employment was up by 1.6% in October, with an average monthly gain of 173,000 jobs. The index of aggregate hours worked in the nonfarm business sector climbed by 2.4% over the same period and average hourly earnings climbed by 2.6%. All these measures suggest systematic improvement in the nation’s labor market during the past year.
The unemployment rate edged up in October (to 5.5%), but even this change has its favorable features. Employment growth as measured by the household survey was strong (298,000) but the labor force rose by a greater amount — resulting in a higher number of people counted as unemployed. The entry of people into the labor force actually bodes well for employment and GDP growth down the line.
Inflation alarms are ringing, and oil is not the issue at this point …
Strong GDP growth can put upward pressures on inflation, particularly when increases in hourly labor compensation and decreases in productivity growth result in rising labor costs per unit of output. Indeed, unit labor costs are always on the Fed’s radar screen, and there’s no question that a bit of trouble has just cropped up on that front.
The Fed ultimately is concerned with core inflation (excluding prices of food and energy), and a variety of factors can put upward pressure on the core — including rising unit labor costs, rising commodity prices and rising prices for non-oil imports. These factors have been conspiring to raise core inflation from the rock-bottom levels a year ago, and recent readings undoubtedly have given our central bank a bit of heartburn.
The core Producer Price Index (PPI) for finished goods rose at an annualized rate of 4% in October, and the October reading was up 1.8% from a year earlier. While rising inflation at the producer level need not translate directly into core consumer prices (the Fed’s major focus), the PPI does show that U.S. producers have regained some pricing power.
The Consumer Price Index (CPI) for October confirms the evolving upward pressure on core inflation in the U.S. The core CPI rose at a 2.5% annualized rate and the October reading was 2% above a year earlier. The chain-core CPI (incorporating floating weights) was up 1.7% on a year-over-year basis, still within our estimate of the Fed’s “tolerance range” but more than double the pace a year earlier.
The Fed hikes short-term rates again and another adjustment is likely in December …
As expected, the Fed enacted another quarter-point increase in its federal funds rate target at the Nov. 10 meeting of the Federal Open Market Committee (FOMC). This was the fourth consecutive increase since June 30, taking the funds rate to 2% and the bank prime rate to 5%.
The Nov. 10 FOMC statement contained assessments of risks to the short-term economic outlook that were identical to the assessments made at the Sept. 21 meeting, and the statement continued to talk about a “measured” pace of future rate hikes — as the Fed continues to remove monetary policy “accommodation” from the financial system. But the Fed’s Nov. 10 reading of current economic conditions showed more positive assessments of economic growth and labor market conditions as well as a less sanguine view of inflation and longer-term inflation expectations.
Data received since Nov. 10, including the surprisingly high readings on core PPI and CPI inflation, are in alignment with the Fed’s assessment of current and evolving economic conditions. As a result, there’s now a high probability of another quarter-point hike in the federal funds rate at the Dec. 14 FOMC meeting, and NAHB’s forecast now incorporates this adjustment. We’re still projecting a funds rate of 3.5% by the end of next year.
Long-term rates are firming up and further increases are in the cards …
Long-term interest rates gravitated downward during the July-October period, despite the process of monetary tightening launched by the Fed on June 30. During this period, bond prices rose and long rates fell as market participants questioned the strength of the economic expansion, downplayed both inflation pressures and the future course of Fed policy and labored under pre-election uncertainties.
Long-term rates have moved up to some degree as the political scene has been clarified and the economic scene has displayed stronger performance and more inflation pressure. NAHB’s forecast still shows percentage-point increases in long-term interest rates over the next year, taking the fixed-rate mortgage yield to 6.75% by the fourth quarter of 2005.
The housing market remains quite strong, but further growth will be difficult to achieve …
As expected, housing starts rebounded in October from the weather-depressed September pace while issuance of building permits edged downward. On a trend basis, the housing markets have been on a high plateau since late last year, with single-family activity hovering around record highs and multifamily production holding in a highly respectable range of 325,000-375,000 units. The resilience of the overall multifamily market reflects strong growth in the condo (for sale) component along with some retreat in production of market-rate rental units.
The housing outlook is quite good for the balance of this year and in 2005, as ongoing improvements in employment and household income fortify housing demand in the face of a rising interest rate structure. It will be difficult to surpass 2004’s record-breaking performances in the economic and financial market environment projected for next year, but any softening in housing markets should be quite limited. NAHB’s forecast currently shows declines of roughly 5% for home sales and housing starts in 2005.
Oil prices stack up as the biggest risk in the economic and housing outlook …
NAHB’s forecast depicts systematic declines in global oil prices from recent record highs. But what if oil prices remain stubbornly high or even surge to new records in 2005?
The Fed can serve as a balance wheel if high oil prices weaken GDP growth and job formation, but we may not be able to count on our central bank to save the day. So far, the Fed has noted that high oil prices have had little impact on the real economy as spending by businesses and consumers has been well maintained. Nor has the oil price surge fed into core inflation to a significant degree, since that process takes a more extended period of time to develop.
What if oil prices hang high — or rise further; consumers and businesses come to view the increases as more than temporary; and weaker spending patterns jeopardize the economic expansion? And what if, by then, high oil prices are feeding into the core inflation rates? The Fed would most likely greet emergence of such a “stagflation” problem with an emphasis on price stability, going ahead with its march toward monetary neutrality despite flagging economic activity.
This combination of events would spell big trouble for housing. Perhaps recent declines in oil prices will continue on our projected path, taking the unpleasant stagflation scenario off the radar screen.
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 Nov. 17 edition. To subcribe to “Eye on the Economy,” click here.
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