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Eye on the Economy: Rebounding From a 'Soft Patch'
 The Economy Still Is Fundamentally Sound
Incoming data support our contention that growth of U.S. economic output (real Gross Domestic Product) is rebounding nicely from a temporary “soft patch” late last year. We’re still estimating GDP growth at 4.8% for the first quarter of this year, up from 1.6% in the final quarter of 2005.
Recent employment trends clearly show solid economic momentum following some hurricane-related weakness last fall. Payroll employment grew by 243,000 in February, and the January-February average stands at 207,000 — above the average for the past year.
Furthermore, weekly data on claims for unemployment insurance suggest that a comparable gain is in the cards for March.
Tightening Resource Markets Will Force an Economic Slowdown Before Long
The current economic expansion now is several months into its fifth consecutive year — and several years of above-trend performance have tightened resource markets and laid the groundwork for a slowdown in GDP growth toward a more sustainable pace. We expect this slowdown to begin in the second quarter and extend through 2007.
The key resource issue is the U.S. labor market. The unemployment rate fell to a cyclical low in the January-February period, the pool of available labor has been dwindling and the labor force participation rate appears to be stuck at about 66%. In addition, growth of average hourly earnings has been on the rise, symptomatic of a tightening labor market.
The early years of this economic expansion were fed not only by a large pool of available labor but also by a large supply of unutilized capital equipment that developed during the investment boom of the late 1990s. But capacity utilization rates have risen considerably since mid-2003 and now are back to pre-recession levels.
Growth of labor productivity (output per hour) has slowed in the process, making it more and more difficult to maintain above-trend GDP growth with low inflation.
Core Inflation Still Is Holding in a Narrow Range
The systematic reduction of slack in labor and capital markets puts upward pressure on labor cost per unit of output, and unit labor cost historically has been the key driver of core inflation in the U.S. This connection establishes limits to the amount of above-trend economic growth that our central bank will tolerate.
So far, key measures of core inflation have been remarkably well-behaved, despite the documented pickup of unit labor costs as well as historically high energy costs that have the potential to leak into the core. Indeed, the year-over-year increase in the core Producer Price Index was only 1.7% in February, well below the pace a year earlier, and the chain-core Consumer Price Index (CPI) was up by only 1.8% in February. The chain-core CPI is a key inflation signpost for the Fed, and this measure still is below the top of the Fed’s implicit “comfort zone.”
The Fed Will Continue to Hike Short-Term Rates Despite Good News on Inflation
The Fed firmly believes that upward pressures on inflation are building below the surface, and further rate increases by the central bank are likely — despite the recent benign readings on core price inflation.
Another quarter-point increase in the Fed’s target for the federal funds rate is a virtual certainly at the next Federal Open Market Committee (FOMC) meeting on March 28 (to 4.75%). The public statement issued by the FOMC at that time should give important clues regarding future monetary policy adjustments.
At this point, we’re assuming the Fed will enact yet another quarter-point increase at the May 10 FOMC meeting and then go on hold for an extended period of time.
The Economy Has Relied Heavily on House Price Appreciation
Personal consumption expenditures grew at a robust 6.5% pace in 2005, accounting for 70% of the level of GDP and contributing a similar portion to the overall GDP growth rate. However, disposable personal income grew by only 4.3% last year, and the strength of consumer spending drove personal saving deeply into the negative zone. Negative saving was accomplished via debt-financed consumer spending, and the Federal Reserve’s household debt service ratio (debt payments to disposable personal income) was driven to a record high in the process.
These borrowing and spending patterns seem to suggest irresponsible behavior on the part of America’s households as well as an unstable situation that could deteriorate rapidly as consumers regain their senses. However, the Fed’s national balance sheets show very strong growth in household net worth during 2005 to a record $52.1 trillion, despite an 11% increase in liabilities (including a 14% increase in home mortgage debt).
Strong growth in household assets was driven by a 15% gain in the market value of real estate, and most of this gain represented holding gains on homes generated by strong price increases (the rest was net investment).
Housing equity grew by 16% during 2005 to a record $11.2 trillion and the housing debt-to-equity ratio actually came down a bit during the year.
The Housing Wealth Effect Will Continue to Support the Economy
It’s clear that strong house price appreciation fueled consumer spending and allowed negative saving in 2005 while strengthening the overall household balance sheet at the same time. Indeed, housing equity and household net worth now are so large that this force will continue to support consumer spending in 2006-2007 even if house price appreciation slows down (as we expect).
It’s also worth noting that the wealth effect is the dominant force, rather than the “realization” or “withdrawal” of capital gains on housing via borrowing (cash-out refinancings or home equity loans). Everything considered, the support to consumer spending provided by the housing wealth effect should be considerable during the 2006-2007 forecast period but not quite up to recent standards.
The Housing Forecast Still Looks Good, But Downside Risks Are Significant
Recent changes to NAHB’s forecast are concentrated in the interest rate structure and the housing sector. On the rate front, we’ve added another quarter point to the Fed’s rate-hike cycle (on May 10) and bumped up most of the interest rate structure by 10 to 20 basis points.
These changes result in reductions in housing starts and home sales for 2006-2007 that are a bit deeper than in the previous forecast. These adjustments result in a slightly weaker pattern for the residential fixed investment component of GDP, but we’ve retained the overall GDP growth pattern by hiking exports and nonresidential fixed investment slightly — including investment in nonresidential structures.
The kind of sectoral rotation we’re forecasting is tricky business, of course, and housing definitely faces higher risks than earlier in the economic expansion. For one thing, an abnormally large share of national employment growth has been concentrated in housing and housing-related industries, and job losses in these areas may be hard to replace in the other sectors that we expect to take up the slack.
Another nagging concern relates to potential shifts in behavior by those investors/speculators that overheated the single-family and condo markets last year. We’re fully expecting reductions in investor purchases, and we view that as a healthy development. But we’re definitely in uncharted waters when it comes to investor behavior, and large-scale cancellations of sales, along with dumping of units owned back onto the markets, would be more trouble than we’re anticipating.
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 22 edition. To subcribe to “Eye on the Economy,” click here.
 Want to Know Your State and Metro Forecasts for 2006?
Anticipate the trends, make better decisions and improve your bottom line. HousingEconomics.com, the online publication from NAHB Economics Group, is your single source for market analysis, forecasts, housing statistics and more. In-depth analysis and detailed Excel tables and overviews are available for all the state and metro forecasts.
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- Home Builders Forecast ― state, metro, non-residential, remodeling, etc.
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- Housing Market Statistics — 29 tables including housing starts, home prices, building permits, home sales, value of new construction, etc.
- Housing Activity
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For more details, visit www.housingeconomics.com.
 Attend the Spring Construction Forecast Conference in April
Plan to attend NAHB's Construction Forecast Conference on April 27 at the National Housing Center in Washington, D.C. The conference brings together the nation's premier housing economists and finance experts for an in-depth examination of the economic outlook for the housing industry.
For more information, visit www.nahb.org/cfc.
Give Us Your Perspective on the NAHB Economics Blog
Give your economic perspective on NAHB's economics blog, “Seiders on Housing,” an informal Internet-based forum dealing with economic issues, housing trends, survey research and other topics affecting the housing sector of the economy.
Log onto the blog at http://nahbblog.blogs.com and get direct access to NAHB Chief Economist David Seiders' expert opinions, projections and responses. Then let Seiders know what you think.
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