Eye on the Economy
The National Economic Expansion Still Is Intact
The 2001 economic recession is now four years behind us, and growth of U.S. economic output (real GDP) has been quite good for the past three years. The economy also has shown an impressive ability to shake off serious shocks, including the unprecedented hurricane season last fall.
We’re now in the “middle innings” of the current economic expansion, and the next economic recession is not yet in sight. Gathering forward momentum in the global economy, along with reassuring developments in world energy markets, bode well for the U.S. economy down the line.
The National Labor Market Is Performing Well
The early stages of the current economic expansion were not strong enough to strengthen the U.S. labor market, as a dramatic surge in labor productivity (output per hour) allowed businesses to meet growing demands for economic output with fewer and fewer workers. But labor market conditions have improved substantially since mid-2003, at least on a national basis.
Payroll employment growth was quite good last year, despite temporary disruptions from the hurricanes, and job growth will essentially mirror that performance in 2006. The unemployment rate now is hovering around a cyclical low, with growth in employment moving about in tandem with labor force growth, and a slight further decline is in the cards as the economy moves ahead in 2006.
The Economy Is Not Generating Serious Inflation Pressures
The U.S. economy had an uncomfortable brush with deflation (falling prices) in 2003. The strengthening of economic growth and job formation since then has lifted “core” inflation rates (excluding prices of food and energy) into a higher zone, although recent rates still are quite low on an historical basis.
Rising labor costs, along with some inevitable pass-through of high energy costs, are likely to place some additional upward pressure on core inflation in 2006. However, core consumer price inflation should not move above the upper end of the Federal Reserve’s apparent “tolerance range,” and overheating is not a proximate threat to the U.S. economic expansion.
The Federal Reserve Is Nearing the End of Its Rate-Hike Cycle
The Federal Reserve cut short-term rates aggressively to limit the 2001 recession, support the early stages of economic expansion and fight off the deflation threat in 2003. The Fed started to withdraw monetary stimulus from the economy at mid-2004 and has raised short-term rates by a cumulative 3.25 percentage points since then.
The Fed wants to get monetary policy into a “neutral” position (neither stimulating nor impeding economic growth), and minutes from the last Federal Open Market Committee (FOMC) meeting on Dec. 13 show that policymakers believe that process is nearly complete. Another quarter-point rate hike is likely at the next FOMC meeting on Jan. 31 (Fed Chairman Alan Greenspan’s last meeting), and monetary policy most likely will be held steady during the first year of Ben Bernanke’s tenure as Fed chairman.
Long-Term Interest Rates Are on a Modest Upswing
Long-term interest rates fell substantially during the 2000-2003 period and have changed little, on balance, since then — despite the Fed’s systematic increases in short-term rates since mid-2004. This combination of developments was dubbed a “conundrum” by Greenspan some time back, and a dramatic flattening of the Treasury yield curve recently touched off alarms in financial markets and the forecasting community — since yield curve inversions often were followed by economic recessions in the past.
Long-term rates actually have firmed up in recent months, and some further increase is in store for 2006. Thus, the Treasury yield curve will not invert decisively in 2006, as long as the Fed manages monetary policy as expected. In any case, a yield curve inversion is not a reliable precursor of economic recession in today’s world.
Housing Market Activity Has Begun to Cool
The U.S. housing market expanded dramatically in recent years, and new records for home sales, single-family starts and residential remodeling were set in 2005. Prices of single-family homes and condo units soared in the process, posting double-digit gains on a national average basis.
Affordability issues created by the combination of soaring house prices and a rising interest rate structure began to weaken housing demand to some degree in the latter part of 2005. Sales of new and existing homes have moved down modestly from recent peaks, and both housing starts and building permits have started to fade. Forward-looking surveys of single-family builders and home mortgage lenders suggest that the cooling process extended through the end of 2005 and into 2006.
Home Sales and Housing Production Will ‘Simmer Down’ in 2006
The retreat in housing market activity that’s now underway amounts to a “simmering down” process from unsustainably hot market conditions in 2005 — rather than a classic cyclical contraction that could spiral downward for some time. The projected economic and financial market conditions discussed above are key to this favorable outcome for housing.
NAHB’s housing forecast for 2006 shows home sales and conventional housing starts coming off the 2005 highs but remaining comparable to the excellent performances of 2004. In the process, home price appreciation is expected to slow down considerably but remain comfortably in the positive zone.
Some components of housing production actually will show ongoing real (inflation-adjusted) growth in 2006, including shipments of manufactured (HUD-code) homes, residential remodeling and starts of market-rate rental housing. Everything considered, the housing production component of GDP (residential fixed investment) will transition from a powerful economic growth engine to a slight drag on GDP growth.
Economic and Housing Market Performances Still Vary Widely Across Geographic Areas
The 2001 recession was concentrated in the manufacturing sector of the economy and in the geographic areas with heavy concentration in manufacturing — particularly the industrial Midwest. Indeed, the job market in Michigan contracted in 2005 for the fifth consecutive year, and employment levels in Ohio, Illinois and Indiana are still well below pre-recession peaks.
Housing markets performed surprisingly well in hard-hit economic areas, at least through 2004, as the historically low interest rate structure fueled home buying by renters and trade-up activity by home owners with jobs. But the weight of cumulative job market losses took a serious toll on Midwest housing markets in 2005 even as the national market soared to new record highs. Another year of national and global economic expansion, along with a lower dollar, should help firm up the Midwest economies in 2006, although the higher national interest rate structure and persistent out-migration from the Midwest region will keep housing markets in that part of the country relatively weak for some time.
Downside Risks to the Economy Reside Largely Within the Housing Sector
The housing sector has made unprecedented positive contributions to U.S economic growth in recent years. These contributions have come through two major channels:
- Home sales, housing production and stimulus to industries closely related to housing market activity
- Rapid rates of house price appreciation that generated huge amounts of housing equity that, in turn, stimulated consumer spending and allowed households to run current saving to zero or below (via borrowing and spending beyond current income)
The recent surges in home sales, housing production and home prices were related partly to surges in investor/speculator activity in single-family and condo markets. Furthermore, proliferation of “exotic” forms of adjustable-rate mortgages helped fuel buying by marginal home buyers as well as by investors/speculator looking for quick capital gains.
It’s possible that quick reversal of these special factors could badly weaken housing markets, send investors/speculators scurrying to the sidelines, provoke sizeable house price declines, cut into housing equity and provoke a snapback in the personal saving rate that would cut seriously into consumer spending. But the probability of such an outcome is quite low, and the orderly cooling process that’s now underway is in line with the “simmering down” pattern in NAHB’s forecast.
Maintaining the Housing Policy Structure Is Critical for Both Housing and the Economy
NAHB’s forecasts assume that current U.S. housing policy is maintained. This means, in particular, that the housing GSEs (Fannie Mae, Freddie Mac and the Federal Home Loan Bank System) are not seriously weakened and that housing incentives in the tax code are not scaled back. These seem like reasonably good assumptions for 2006, although the housing policy structure may be more seriously threatened after the mid-term elections.
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 Jan. 4 edition. To subcribe to “Eye on the Economy,” click here
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Log onto the blog at http://nahbblog.blogs.com and get direct access to Seiders' expert opinions, projections and responses.