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Eye on the Economy
 Economic Growth Slows Down, But Only Temporarily
Growth of U.S. economic output slowed down significantly in the final quarter of 2005. Furthermore, output growth in the fourth quarter was dominated by inventory investment in the nonfarm business sector while final sales of domestic product were quite weak — a compositional shift that ordinarily has negative implications for ensuing GDP growth.
Several factors conspired to pull down economic growth in the final quarter of 2005 — lower federal defense spending; downward pressure on construction activity from unusually bad weather in December; a post-hurricane drag from lost energy and other production in the Gulf region; the impact of the energy price shock on consumer discretionary income and spending; and a large decline in motor vehicle production as sales fell sharply once the automakers’ generous incentive programs came to an end. The decline in auto sales was so sharp that inventories of motor vehicles and parts surged in the fourth quarter (despite the substantial downshift in production), providing a partially offsetting positive punch to GDP growth.
GDP growth should firm up in the first quarter of this year as energy production recovers from hurricane-related shutdowns, weather effects swing from negative to positive, auto sales pick up and production stabilizes, and federal defense spending moves back into the positive growth range.
Indeed, we expect solid contributions to first-quarter GDP growth from consumer spending, nonresidential fixed investment (including structures) and the government sector (federal, state and local). We’re projecting trend-like GDP growth for 2006 as a whole with a modest slowdown late in the year as temporary hurricane-induced positives provide less support to the economy.
The Labor Market Is Still in Gear
The employment report for December was somewhat disappointing, but the labor market remains fundamentally healthy. Growth of payroll employment was unexpectedly weak (108,000), but the gain for November was revised up substantially and the fourth-quarter average was right on target. Payroll employment grew by 2.02 million over the course of 2005, essentially the same as in 2004, and we’re projecting similar growth in 2006.
The unemployment rate edged down to 4.9% in December — equivalent to the cyclical low hit several times during the second half of 2005. The December decline reflected trend-like growth of civilian employment and a slight decline in the civilian labor force.
We’re looking for good growth in both employment and the labor force this year, holding the unemployment rate around 5.0% — a level that approximates “full employment” but that should not generate inflationary increases in unit labor costs (assuming maintenance of solid productivity growth).
‘Core’ Inflation Still Is Very Much Under Control
Key measures of core producer and consumer price inflation (excluding prices of food and energy) remain very much under control despite potential upward pressures on business cost structures from tightening labor markets and the pass-through of high energy prices.
Core producer price inflation was only 1.7% in both November and December of 2005 (year-over-year basis), well below the pace earlier in the year. The core consumer price index (CPI) picked up a bit of steam late in the year, rising to a 2.2% pace in December (year-over-year), and this report raised a few eyebrows in financial markets. However, the technically superior chain-core CPI (allowing for substitutions by consumers away from higher-priced goods and services) held at an historically low 1.7% pace.
The Greenspan Fed Will Hand Over Neutral Policy to Ben Bernanke
The Fed hiked its federal funds rate target to 4.25% at the conclusion of the Dec. 13 meeting of the Federal Open Market Committee (FOMC), and minutes from that meeting suggest that the central bank is nearing the end of the systematic rate-hike cycle that began in June 2004.
Our forecast continues to assume another quarter-point increase at the Jan. 31 FOMC meeting, the last one under Alan Greenspan.
The Senate presumably will approve the President’s nomination of Ben Bernanke as the new Fed chairman by Feb. 1, and Bernanke’s first FOMC meeting will take place on March 28.
Bernanke may want to establish his own inflation-fighting credentials with a quarter-point rate hike at that meeting, despite some obvious questions about the vitality of the economy and plenty of good news on core inflation. But our forecast still shows steady Fed policy during the early stages of the Bernanke Fed, under the assumption that a 4.5% federal funds rate is essentially “neutral” with respect to the impact of monetary policy on the economy.
Long-Term Interest Rates Recede From Late-2005 Levels
The obvious slowdown in economic growth, the benign core inflation environment and the prospects for near-term stability of monetary policy have had soothing effects in bond and mortgage markets.
The Treasury yield curve now is essentially flat, and the anticipated quarter-point hike in short-term rates by the Fed on Jan. 31 is likely to provoke a mild inversion. This development will neither deter the Fed nor lead to recession, contrary to some speculation in financial markets and the forecasting community. But where will long-term rates go?
We continue to believe that a flat (or inverted) yield curve is unsustainable, that the Fed will not drop short rates to “cure” the situation, and that long rates will have to gravitate upward before long. Having said that, we’ve been compelled to cut our estimates of first-quarter long-term rates and reevaluate the patterns for the balance of the 2006-2007 forecast horizon. Stay tuned.
Housing Markets Are ‘Simmering Down’ in Various Parts of the Country
The accumulation of rapid house price gains has been taking a toll on affordability conditions in many markets for some time, and the upshift in the interest rate structure during the latter part of 2005 certainly made home buying more difficult in most places. As a result, most housing market indicators “rolled over” by the fourth quarter of last year and the long-awaited “cooling” process apparently extended into the early part of 2006.
Patterns of home sales, housing starts and building permits are consistent with the hypothesized cooling process, although it’s fair to say that seasonal adjustment difficulties during the winter months make identifying the underlying trends and cycles difficult. NAHB’s surveys of single-family builders provide the most compelling signs of a housing slowdown, although our Housing Market Index stabilized in January following systematic deterioration during the second half of 2005.
Everything considered, it’s fair to say that housing has come off the late-2005 peaks but that levels of activity remain quite high by historical standards. This view is consistent with the summary assessment contained in the Federal Reserve’s Jan. 18 “Beige Book” — the commentary on current economic conditions developed by the 12 Federal Reserve District Banks.
The Degree of Housing Decline Will Depend Heavily on Long-Term Rates
The forecasting community (including yours truly) underestimated the strength of the single-family and condo markets in both 2004 and 2005, primarily because long-term interest rates turned out to be much lower than projected. Furthermore, highly aggressive lending practices in adjustable-rate mortgage markets encouraged investors/speculators and added heat to the housing markets in many areas.
Our housing forecasts for 2006-2007 are based on the premise that home sales in 2005 contained an unsustainable element that amounted to as much as 7% of home sales and single-family/condo production.
We’re confident that actions by financial regulators and rating agencies will cause a pullback in “exotic” forms of adjustable-rate loans (a Greenspan term) and discourage some investors/speculators in the process. But we’ve also been projecting significant increases in long-term mortgage rates in 2006, and the movement has been in the opposite direction.
We’ll just have to keep an open mind as financial and housing market data continue to pour in…
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. 25 edition. To subcribe to “Eye on the Economy,” click here.
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