Eye on the Economy
By David F. Seiders, NAHB Chief Economist
Growth of U.S. economic output drives improvement in the labor market …
Real gross domestic product (GDP) apparently expanded at a rapid pace in January, primarily reflecting a surge in business inventory investment. Monthly indicators of spending and production — including retail sales, housing starts and industrial production — show good forward momentum through February, and first-quarter GDP appears to be on a strong growth path despite persistent weakness in our trade sector (strong imports and weak exports). We’re projecting 4.0% growth for the quarter, with a similar pace in the second quarter of the year.
Above-trend growth in economic output is keeping the labor market in gear. Payroll employment growth averaged a highly respectable 197,000 for the January-February period, and weekly data on claims for unemployment insurance suggest at least that strong a pace in March. Furthermore, there’s apparently a good deal of slack remaining in the labor market. Our projected GDP pattern should continue to generate solid job growth with limited upward pressure on unit labor costs (and core inflation).
Core inflation is firming up, sorely testing the Fed’s patience …
Core inflation (excluding prices of food and energy) has been firming up since late 2003, and persistent upward pressures from commodity markets, imports and the labor market are under close scrutiny by financial markets as well as the Federal Reserve. So far, core inflation has been under reasonably good control and longer-term inflation expectations appear to be well-anchored. However, more serious upward pressure is likely as the economic expansion churns through its fourth consecutive year.
The core producer price index (PPI) for finished goods posted a year-over-year advance of 2.8% in February, the biggest 12-month increase in more than a decade and definitely an unsettling inflation signal. The core consumer price index (CPI) showed a 2.3% year-over-year advance in February, and the technically superior chain-core CPI posted a 2.0% gain. These readings also were on the high side of recent experience and contributed to the thickening inflation plot.
The Fed notches short-term rates up further and projects future adjustments at a ‘measured pace’ …
As expected, the Fed enacted another quarter-point increase in its federal funds rate target at the March 22 meeting of the Federal Open Market Committee (FOMC). This adjustment took the funds rate to 2.75%, up from 1.0% at mid-2004 when the Fed started to remove monetary policy “accommodation” from the economy. The series of funds rate adjustments, in turn, has raised the bank prime rate from 4.0% to 5.75%.
The FOMC statement of March 22 once again specified that remaining policy accommodation can be removed “at a pace that is likely to be measured.” However, the statement noted that “pressures on inflation have picked up in recent months and pricing power is more evident” and stressed that “appropriate monetary policy action” will be needed to maintain an even balance of risks to sustainable economic growth and price stability.
Despite some marked similarities to previous FOMC statements, the March 22 statement definitely conveyed growing concerns on the inflation front. Another quarter-point increase is highly likely at the next FOMC meeting on May 3, and a half-point increase can’t be ruled out at that time. We still expect the funds rate target to be 3.75% at year end — taking the bank prime to 6.75%. There definitely are upside risks to this forecast, however, and the path of core inflation will be the key swing factor as we move ahead.
Long-term interest rates finally move up, easing Greenspan’s ‘conundrum’ …
In mid-February, Fed Chairman Alan Greenspan told the Congress that declining long-term rates and a flattening yield structure posed a “conundrum” in U.S. and global financial markets. Not only was Greenspan hard-pressed to explain the behavior of long-term rates since mid-2004 (when the Fed started to hike short-term rates), but he also appeared unhappy with the refusal of long rates to move up.
Greenspan’s comments apparently had some effect on bond market psychology, and the March 22 FOMC statement really nailed things down. Yields on both 10-year Treasury bonds and fixed-rate home mortgages have moved up by roughly 50 basis points since mid-February, placing these long-term rates a bit above NAHB’s forecasts for this point in time. We’re expecting additional half-point increases in both bond and mortgage rates over the balance of the year, moves that would take these measures to about 5.0% and 6.5%, respectively.
The housing market turns in a strong performance early in 2005 …
Housing starts for January have been revised upward and the preliminary estimate for February shows another increase — to a 21-year high for total starts and an all-time high for the single-family component. The multifamily sector also posted historically high numbers for the January-February period, driven by a strong condo component as well as an improving rental market.
Issuance of building permits also was robust in the first two months of the year (both single-family and multifamily), and a sizeable backlog of unused permits at the end of February points toward another strong housing starts number for March.
Furthermore, surveys of both home builders and mortgage lenders confirm ongoing strength in the single-family sector. NAHB’s Housing Market Index for March held at the elevated level of recent months, and weekly data on applications for mortgages to buy homes (Mortgage Bankers Association series) reinforce the pattern of strength.
It’s now clear that the housing production component of GDP (Residential Fixed Investment) will post another solid growth rate in the first quarter, extending the remarkable pattern that has prevailed during the entire economic recovery/expansion period. Indeed, RFI growth has averaged more than 8% since early 2002, more than double the growth of overall GDP.
The housing outlook looks bright despite mounting complications …
Much of the first-quarter strength in housing market activity occurred before the upshift in long-term interest rates, and further increases in the entire interest rate structure are in the cards as we move ahead. The inevitable interest-rate drag on housing demand will be at least partially offset by ongoing growth in employment and household income, but the net effect of all these factors most likely will be modestly negative.
A second complication in the housing outlook relates to an apparent surge in home buying by investors and speculators, financed to some degree by highly aggressive mortgage instruments — such as low-documentation, interest-only, adjustable-rate mortgages with deeply discounted initial rates. It’s not clear how much of the recent record levels of home sales and single-family housing starts reflected the efforts of investors and speculators to garner quick capital gains, and to what degree the homes they bought are poised to come back onto the market at the first hint of price weakness.
NAHB has been canvassing builders and local home builders associations about the investor/speculator phenomenon, and we’ve uncovered a good bit of concern in a number of hot metro housing markets. Indeed, many builders are taking steps to prevent sales to buyers who do not intend to occupy the homes.
I’ll be giving more detailed reports in future issues regarding our survey findings as well as our assessment of the implications of the investor/speculator phenomenon for the housing markets down the line. For now, we’ve retained 2005-2006 forecasts for home sales and housing starts that show only modest erosion (3%-4%) from the robust performances of 2004. Stay tuned.
The home equity ‘buffer’ continues to strengthen …
The recent acceleration of house price growth, particularly in hot metro markets along the coastlines, may very well reflect aggressive investor/speculator buying. If so, price levels in those areas are vulnerable to a bail-out by speculators, and subsequent price declines conceivably could erode home owner equity, weaken the quality of home mortgages and threaten the health of mortgage investors and mortgage insurers.
Greenspan discussed this potential problem on Capitol Hill in mid-February. While conceding that house prices exhibit “bubble” characteristics in some local areas, Greenspan argued against a national house price bubble and downplayed the consequences of potential price declines in vulnerable local markets.
Greenspan pointed out that past price increases in high-froth markets had created a large home equity “buffer” that would protect most home owners (and mortgage investors/insurers) in the event of price reversals. Indeed, the Fed’s national balance sheets show a record $9.6 trillion in housing equity at the end of 2004 despite rapid growth of home mortgage debt in recent years, and the overall debt-to-value ratio is only 44% — the same as a year earlier.
Resurgent oil prices threaten the outlook for housing and the economy …
Global oil prices hit a record high last October ($56.37 for WTI) and then receded quite a bit in the following months (to $40.71 in early December). But oil prices surged again in February and March, recently rising above the records of last fall.
This unanticipated resurgence, if not reversed in short order, could weaken economic growth and infect core consumer inflation rates over time, threatening a demoralizing “stagflation” process that the Fed would be hard-pressed to counter. Such an outcome definitely would be negative for the housing sector.
We believe that the current oil price surge is at least partly weather-related and that the fundamentals of global supply and demand will shepherd oil prices downward. Our forecast shows systematic declines from the first-quarter highs, with the WTI price receding to $42 by the end of this year and to $38 by late 2006. Global oil prices are subject to a host of uncertainties, of course, and it’s fair to say that oil will remain a wild card for some time to come.
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 23 edition. To subcribe to “Eye on the Economy,” click here.
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