Eye on the Economy
By David F. Seiders, NAHB Chief Economist
The economic expansion still looks healthy despite revisions to history …
Benchmark revisions to the national economic accounts for the 2002-2004 period show slower growth of real Gross Domestic Product (GDP), slower growth of labor productivity, stronger growth of unit labor costs and higher rates of inflation. While these are all negatives for the U.S. economy, the economic recovery/expansion since the 2001 recession still looks quite healthy and there’s still plenty of room for growth.
GDP growth for the first quarter of this year still stands at a highly respectable 3.8% pace, but the Commerce Department’s “advance” estimate for the second quarter shows a slowdown to 3.4% (a bit below our projection). This estimate may very well be revised upward but, in any case, the composition of second-quarter GDP has set the stage for a solid rebound in the third quarter of the year.
The labor market continues to expand and compensation strengthens …
The labor market report for July was quite upbeat, showing strong growth of payroll employment, a pickup in the labor force participation rate and maintenance of a 5% unemployment rate. The report also showed a significant increase in average hourly earnings, good news for workers but a factor that may feed into unit labor costs and inflation down the line (depending on the pace of productivity growth).
Growth of labor productivity in the nonfarm business sector slowed to a year-over-year pace of 2.3% in the second quarter while hourly compensation (including benefits) grew at an elevated 6.7% pace and labor cost per unit of output was up by 4.3 percent ― the fastest rise in five years. These developments definitely kept concerns about core inflation on the front burner.
Energy prices surge again but 'core' inflation remains under control …
Crude oil prices have been hitting record highs in recent weeks and the price of gasoline at the pump has climbed to new records as well. Even so, spending by businesses and individuals has moved ahead nicely, a least partly reflected in record sales of SUVs and other light trucks in July. We’re betting that energy prices will not seriously weaken the U.S. economy during the 2005-2006 period, although there’s certainly the risk of a major supply shock in an already tight market.
The core components (excluding prices of food and energy) of the Producer Price Index (PPI) and the Consumer Price Index (CPI) decelerated to some degree in June. The Fed’s favorite inflation gauge — the core price index for Personal Consumption Expenditures ― showed a year-over-year rise of 1.9% in June, down from other recent readings, and the market-based version was up by only 1.6 percent. Even so, both versions were up by 2% on a year-to-date basis, at the upper end of the Federal Reserve’s apparent comfort zone for both 2005 and 2006, and the recent increases in unit labor costs suggest additional upward pressure on core inflation down the line.
The Fed continues to raise short-term rates at a 'measured' pace …
Fed Chairman Alan Greenspan delivered the Federal Reserve’s semi-annual Monetary Policy Report to the Congress on July 20 (Senate) and July 21 (House of Representatives). Greenspan’s testimony displayed a good deal of optimism about the economic outlook, noting that policymakers expect “sustained economic growth and contained inflation pressures.” In the process, Greenspan stressed that the Fed’s baseline outlook “will require the Federal Reserve to continue to raise short-term interest rates."
As expected, the Federal Reserve hiked short-term rates by another 25 basis points at the conclusion of the Aug. 9 meeting of the Federal Open Market Committee (FOMC), raising the federal funds rate target to 3.5% and pushing the bank prime rate to 6.5%. The FOMC continued to describe monetary policy as “accommodative” and suggested that upward rate adjustments will continue “at a measured pace.” The FOMC’s assessment of recent economic activity, as well as the characterization of risks to the near-term outlook, reinforced the Fed’s concerns about core inflation and highlighted the Fed’s “obligation to maintain price stability.”
Long-term rates firm up but only moderate increases lie ahead …
Greenspan devoted a large part of his July 20-21 monetary policy testimony to the substantial decline in long-term interest rates that’s accompanied the Fed’s progressive increases in short-term rates since mid-2004 — a pattern he described as “without precedent in our recent experience.”
Back in February, Greenspan characterized the behavior of long rates as a “conundrum,” but he now seems much more confident about the fundamental factors at play. He cited four key factors that are restraining long-term rates: low inflation expectations, smaller risk premiums for inflation uncertainty, smaller term premiums for holding long-term securities (because of lessened volatility in the economy), and a global excess of intended saving over intended investment.
Despite these fundamental restraints, long-term rates have moved up significantly in recent weeks, aided and abetted by a surprise revaluation of the Chinese currency that provoked questions about the future of Chinese central bank investment in dollar-denominated assets. The 10-year Treasury yield now is close to 4.4%, up from 3.94% at mid-year, and we expect this rate to exceed 5% by mid-2006. The long-term home mortgage rate should show a similar pattern of change.
The housing market charges through mid-year …
The housing market turned in another strong performance in the second quarter, and the third quarter started out on a high note as well. Total housing starts held firm in June at a 2.004 million pace and starts averaged more than 2 million units for the second quarter as a whole. The housing production component of GDP (residential fixed investment) grew at a robust 9.8% pace in the second quarter, a bit above the first-quarter rate.
Home sales maintained strong forward momentum through June. Sales of existing single-family homes and condo/co-op units both hit new records on a national basis, and all regions but the Midwest posted record numbers. In the new-home market, sales were a record 1.37 million units in June.
Surveys of home builders and home mortgage lenders show that strength in the single-family sector extended into July. NAHB’s Housing Market Index was 70 in July, within the elevated range that’s prevailed for the past year, and the index of applications for mortgages to buy homes (Mortgage Bankers Association series) gravitated upward to a new record during the month.
House price appreciation strengthens further in the second quarter …
Home price appreciation has been unusually strong for the past five years and truly exuberant for the past two years. The most recent repeat-transactions data from the Office of Federal Housing Enterprise Oversight (OFHEO) showed a 10.26% year-over-year gain in the purchase-only measure for the first quarter (excluding refinancings). Other sources of data suggest that the rate of home price appreciation accelerated further in the second quarter of the year.
Price appreciation was quite rapid in the existing-home market during the second quarter, and prices of both single-family homes and condo/co-op units were up by about 15% in June (year-over-year basis). The median price of new homes sold in June was down a bit from a year earlier, but this decline reflected shifts in the regional composition of sales and in the mix of home sales by price range. In this regard, there’s no evidence to suggest that builders are cutting prices to maintain sales volume.
Fannie Mae’s analysis of its own portfolio data (a major input to the OFHEO system) suggests that national home price appreciation accelerated in the second quarter ― at least in the “conforming” market financed by Fannie Mae and Freddie Mac. Fannie’s analysis shows a year-over-year price advance of 14.1% (excluding refinancings), a figure that suggests OFHEO’s second-quarter estimate will turn out to be a cyclical high.
Compositional changes are underway in the housing sector …
Despite record home sales, the nation’s homeownership rate has lost some ground recently while vacancy rates for rental apartments have fallen significantly. Indeed, the absolute number of home owners has stagnated following a strong uptrend while the number of renters has been on the rise following years of serious erosion. These are early signs of fundamental adjustments to the volume and composition of housing market activity in the U.S.
Healthy employment growth is fueling strong growth of renter households while rapid rates of house price appreciation are eroding the affordability of homeownership, particularly in the high-priced Northeast and West regions. Furthermore, a historically high vacancy rate for single-family homes suggests that a significant portion of recent record home sales has gone to investors that are holding units vacant prior to resale in pursuit of capital gains.
The changing balance of affordability between renting and owning, along with the large number of vacant single-family homes, should lead to some erosion of home sales and single-family housing starts before long, and the upper price ranges are likely to be affected the most. We expect this process to be encouraged by a rising interest rate structure as well as by more discipline in ARM lending and some fall-off in speculative home buying.
Housing is headed for a 'soft landing' in 2006 …
NAHB’s forecast continues to project gradual erosion of home sales and housing starts, along with a slowdown in house price appreciation, before the end of this year. We anticipate a “soft landing” for the housing sector in 2006, followed by an extended period of housing production around our long-term forecast level — an annual average of about 2 million units (including manufactured homes).
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 Aug. 11 edition. To subcribe to “Eye on the Economy,” click here
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