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

Housing drives economic growth into the third quarter

The U.S. economy maintained strong forward momentum through mid-2005, extending the cyclical expansion that began around the end of 2001. Real gross domestic product (GDP) grew at a 3.3% annual rate in the second quarter, slower than the first quarter pace but still quite solid.

Indeed, GDP growth came to 3.6% on a year-over-year basis, the same as the first quarter, and final sales of domestic product (excluding a temporary shortfall in business inventory investment) expanded at a robust 5.4% annual rate.

Housing has been a major part of the economic growth picture during the entire economic expansion to date. The housing production component of GDP (residential fixed investment) grew at a 9.8% annual rate in the second quarter and contributed 0.56 of a percentage point to the GDP growth rate — in line with the historically high contributions recorded for 2004 and the first quarter of this year. Housing also has been providing strong support to the economy through stimulus to closely related industries as well as through large wealth effects (generated by rapid home price increases) that have supported consumer spending.

Katrina complicates the economic picture

Available monthly indicators for July and August point toward maintenance of strong GDP growth in the third quarter. However, Hurricane Katrina hit the Gulf Coast region at the end of the August and seriously complicated the economic picture for both the third and fourth quarters. The depth and duration of her impacts will depend largely on the degree of damage to energy extraction, refining and transmission infrastructure in the Gulf region, and to the extensive port facilities in that region as well as on reactions in financial markets (including interest rate declines) to the effects in the energy markets and the economy.

At this point, the economic damage from Katrina looks quite serious but largely temporary. We’ve made significant cuts to our GDP growth forecast for the balance of this year and installed an incomplete recapture in 2006 — on the assumption that energy prices will remain above the pattern assumed in our previous forecast and that interest rate adjustments will not fully neutralize the negative energy effects. Personal consumption expenditure bears the brunt of our downward revision to GDP growth, but we’ve held the housing component at pre-Katrina levels, largely because of the supportive interest rate effect.

Labor markets continue to tighten, at least through August

GDP growth has qualified as “above-trend” for more than two years, and we still expect modestly above-trend growth for the rest of this year and early 2006. This kind of growth generates systematic improvements in the national labor market. Payroll employment gains averaged 194,000 for the first eight months of this year (that’s quite good) and the unemployment rate was down to a cyclical low of 4.9% in August (note that Katrina occurred after the survey period for the August employment report).

The falling unemployment rate indicates that “slack” in labor markets has been reduced substantially during the past two years. That’s definitely good for workers, but shrinking slack in resource markets certainly creates challenges for our inflation-sensitive central bank as the economic expansion proceeds. The issue is labor cost per unit of output, and that’s been on the rise. Katrina will provide, at best, temporary respite from progressively tightening labor market conditions.

Core inflation settles down but doesn’t fall off the Fed’s radar screen

Systematic growth in economic output (real GDP) and gradual tightening of labor market conditions have put upward pressures on labor costs as well as “core” inflation in the U.S. economy (excluding prices of food and energy). Key measures of core consumer price inflation were well behaved in June and July, including the core components of the Consumer Price Index and the key price index for Personal Consumption Expenditures.

Despite the recent readings, core inflation still is well up from cyclical lows in late 2003 and is running close to the upper end of the Federal Reserve’s apparent comfort zone. Furthermore, the Fed has been expressing concern about inevitable “leakage” of high energy costs into the core, and Hurricane Katrina certainly has intensified those concerns.

Monetary policy will march onward, but Katrina may slow the pace

The Fed has been systematically withdrawing monetary policy “accommodation” from the economy since mid-2004, raising its federal funds rate target from 1% to 3.5% in the process. Minutes from the most recent meeting of the Federal Open Market Committee (FOMC) on Aug. 9 highlight the Fed’s growing concerns about core inflation and point toward another quarter-point increase in the funds rate at the next FOMC meeting on Septe. 20.

The Fed has stressed that its policy adjustments are “data dependent,” however, and Chairman Alan Greenspan recently highlighted Fed adoption of a “risk-management approach” to policymaking that provides leeway to move against a low-probability event with a potentially severe negative outcome.

The Fed has continued to say that remaining monetary policy accommodation can be removed “at a measured pace,” and NAHB’s baseline (most probable) forecast has been assuming quarter-point rate hikes at each of the next four FOMC meetings. But it’s likely that the economic disruptions from Hurricane Katrina will encourage a change in Fed policy, and futures markets now show much lower probabilities of near-term Fed rate hikes than before Katrina landed.

Katrina sends long-term rates downward, at least temporarily

Long-term interest rates still are below their levels of mid-2004, despite the systematic increases in short-term rates by the Fed and the upward percolation of core inflation pressures. Furthermore, Hurricane Katrina prompted another downshift at the end of August, dropping the 10-year Treasury yield by about 20 basis points.

A number of fundamental factors have held down long rates, including a surplus of saving on a global basis, and bond market participants obviously are requiring little compensation for committing funds on a long-term basis. NAHB’s forecast assumes that further monetary tightening, revival of various risk premiums and dissipation of Katrina’s negative effects on economic growth will move long-term rates upward, but the increases should not be dramatic. The upward path in our forecast is somewhat shallower than before, for several quarters, although our projected rate structure for the end of 2006 is the same as in our pre-Katrina forecast.

Greenspan says ‘the housing boom will inevitably simmer down’

Greenspan recently argued that lowered risk premiums “have propelled asset prices higher,” and he pinned that charge on stock, bonds and homes. With respect to housing, Greenspan referenced undue optimism about the potential for additional increases in home prices as well as “exotic” forms of adjustable-rate mortgages (ARMs) that have fueled home purchases for owner-occupancy as well as for investment/speculation.

The Fed chairman actually characterized the current “housing boom” as one of “America’s economic imbalances” — along with the huge current account deficit and the seemingly intractable federal budget deficit. Greenspan predicted that “the housing boom will inevitably simmer down,” holding open the possibility that the slowdown process can involve adjustments in interest rates and prices rather than more-wrenching changes in output.

Greenspan’s vision probably is the best bet

The single-family and multifamily condo markets certainly have been quite strong, and sales records recently were set in both markets. Furthermore, national house price appreciation has been accelerating (up to13.4% in the second quarter on a year-over-year basis) and an increasing number of local markets qualify as “boom” areas marked by unsustainable price behavior.

Greenspan’s “simmer down” vision is the most likely prospect. The boom markets inevitably will cool down as the house price increases erode affordability conditions, interest rates rise, lending standards strengthen in ARM markets, speculators move to the sidelines and expectations for further house price increases are scaled back. These adjustments will reflect a combination of natural market forces and efforts by policymakers and financial rating agencies to restore better balance to mortgage and housing markets.

Growing housing equity provides valuable buffer against Katrina’s attack on the economy

The ongoing increases in house values have generated a huge amount of wealth for America’s home owners — about 70% of all households. This phenomenon has allowed households, in the aggregate, to run the national personal saving rate (income less consumption) to historic lows (now around zero) without eroding household sector net worth positions.

Household sector housing equity (housing value less mortgage debt) now is more than $10 trillion, providing a major buffer to household spending against drains in purchasing power created by surging energy costs. Households can borrow against this equity or rely on consumer credit, if necessary, to help weather the storm.

The single-family housing market is heading for a slowdown

Our baseline (most probable) forecast still portrays a “soft landing” for the national single-family housing market, as the downward interest rate adjustments in the wake of Katrina roughly offset inevitable shortfalls in home sales and single-family starts in the affected areas (these areas normally account for less than 2% of national totals) as well as longer-term negative impacts from the higher energy costs. We’re projecting modest erosion of home sales, house price appreciation and housing production beginning before the end of the year.

Our current forecast shows declines of roughly 6% in home sales and single-family starts in 2006, and we expect the national rate of home price appreciation to recede from the double-digit rates of recent times to roughly half that pace next year. Price declines could be recorded in some local markets, but serious setbacks should be avoided as long as economic conditions continue to move forward.

 Don’t Miss NAHB’s Fall Construction Forecast Conference

See what's on the horizon for the housing industry at the semi-annual gathering of the country's premier economists and finance experts. Get the latest forecasts on housing starts, projected budgets and other economic bellwethers at the Fall Construction Forecast Conference on Oct. 19 at the National Housing Center in Washington, D.C. Visit www.nahb.org/conference for more information.

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