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Eye on the Economy: Fed Chair Hints at Another Rate Hike
 A Fade in Economic Growth Is in the Cards Beyond Mid-2006
Strong forward economic momentum extended into the second quarter of this year, but growth of both real GDP and payroll employment should begin slipping to below-trend rates beyond mid-2006. In the process, the unemployment rate should gravitate upward and get back to 5% by mid-2007.
We’re viewing the upcoming slowdown in economic growth and the projected uptick in the unemployment rate as fundamentally positive developments that will help extend the life of the current economic expansion. After all, the expansion is now into its fifth consecutive year, and a lot of above-trend growth has been grinding up slack in labor and capital markets and threatening to generate serious upward pressures on core inflation (excluding prices of food and energy). That’s a real red flag to our inflation-wary central bank.
Inflation Story Remains Good Despite Surging Energy Prices
The Fed has been worried about upward pressures on core inflation from tightening labor markets and soaring energy prices that can make their way into the core through business cost structures. Indeed, history suggests that such pressures are now developing even if current readings on core inflation look benign.
The core GDP price index showed an annualized gain of 3.3% in the first quarter of this year and a year-over-year gain of 3.0% — both on the high side of recent experience. The core price index for the Fed’s favorite inflation gauge, the Personal Consumption Expenditures (PCE), showed an annualized gain of 2.0% in the first quarter and 1.9% on a year-over-year basis.
The top of the Fed’s “tolerance zone” for the core PCE price index apparently is about 2%. So the Fed presumably is prepared to nip underlying inflation pressures in the bud before they materialize at the consumer level.
Fed Chairman Bernanke Hints at Another Rate Hike on May 10
The Fed chairman, Ben Bernanke, testified before the Joint Economic Committee of the U.S. Congress on April 27.
He painted a picture of an economy that had decelerated late last year in the wake of the hurricanes but that had rebounded nicely in the early months of 2006. He also discussed systematic reduction in the degree of slack in resource (labor and capital) markets as well as the complications posed for both real economic growth and core inflation by surging energy prices.
Bernanke also discussed the likelihood of a slowdown in economic growth and job creation as 2006 progresses. And while characterizing the outlook for inflation as “reasonably favorable,” he stressed the upside risks from both labor and energy markets and declared that “vigilance in regard to inflation is essential.”
With respect to future monetary policy moves, Bernanke hinted strongly about another quarter-point rate hike at the next Federal Open Market Committee meeting on May 10, a move that will raise the target for the federal funds rate to 5.0%. He stressed that policy adjustments beyond that point will be data-dependent.
We’re viewing a 5% funds rate as a slightly restrictive monetary policy stance, and we expect the Fed to hold that position throughout the balance of the 2006-2007 forecast period.
Long-Term Interest Rates Are Firming Up, Restoring Some Positive Slope to the Yield Curve
Strong economic indicators, percolating inflation numbers and an obviously resolute Federal Reserve have combined to push long-term interest rates to four-year highs. Indeed, the 10-year Treasury yield has been hanging around 5.1% in recent days and the fixed-rate home mortgage moved up to about 6.6% at the end of April.
Long-term rates currently are a bit above NAHB’s estimate for the second quarter ― and about equal to our forecast for the second half of the year. As long as current expectations for economic growth, core inflation and Fed policy are realized as time goes by, long-term rates should stabilize around current levels.
That’s our current judgment, although our long-term rate forecast could turn out to be too low if term spreads in the yield structure widen out further — imparting more upward slope to the Treasury yield curve.
Home Sales Are Rattling Downward, Inventories of Unsold Homes Are Rising
Surveys of home builders and home mortgage lenders have been painting downward trends for home sales since mid-2005, and the official measures of new and existing home sales have been rattling downward irregularly from peaks reached around that time.
Sales of new homes rose in March, but the average for the first quarter was off by 10% from the final quarter of 2005 and even further below the third-quarter average. Sales of existing single-family homes (based on closings) were about flat in March, but the first-quarter average was down by about 5% from its high in the second quarter of last year. Meanwhile, sales of existing condos were off by 10% from their late-2005 highs.
Pending sales of existing homes ― based on contracts signed ― trailed down during the first quarter, and the March reading was nearly 10% below the monthly high last August.
Inventories of homes for sale have moved upward as sales volume has come down. Inventories of new homes gravitated up to a record 555,000 units in March, a 5.5 months’ supply at the current sales rate. Inventories of existing single-family homes moved up to a record 2.70 million in March, a 5.3 months’ supply, and the inventory of unsold existing condo units soared to 494,000 — a shocking 6.9 months’ supply.
House Price Inflation Is Decelerating, But Affordability Still Is Falling
The rate of house price inflation has been decelerating from peak rates posted during 2005.
The median price of existing single-family homes sold in March was up by 7.8% from a year earlier, well down from the 15% rate of appreciation seen around the middle of last year. In the market for existing condos, year-to-year price appreciation in March was 6.1%, down from rates in excess of 20% early last year.
The multi-year accumulation of rapid house price increases took a heavy toll on housing affordability last year, and affordability has continued to erode as price appreciation has slowed — partly because of a rising mortgage rate structure.
Indeed, the Housing Affordability Index (National Association of Realtors® series) was down by 10% in March (year-over-year basis), reflecting a 4.1% increase in median family income and a 15.6% increase in mortgage qualifying income. The index was down most sharply in the West, where price appreciation has been most robust.
The Housing ‘Soft Landing’ Still Is on Track, But Downside Risks Abound
Bernanke told the Joint Economic Committee on April 27 that the housing market is showing “signs of softening,” and he noted that house prices “appear to be in the process of decelerating.” With respect to the near-term outlook, Bernanke said that the housing sector “will most likely experience a gradual cooling rather than a sharp slowdown.”
However, he quickly added that “significant uncertainty attends the outlook for housing, and the risk exists that a slowdown more pronounced than we currently expect could prove a drag on growth this year and next.”
NAHB’s baseline (most likely) housing forecast for 2006-2007 is fully consistent with Bernanke’s view of the most likely outcome. However, we also recognize substantial downside risks to the “gradual cooling” scenario.
The biggest uncertainty relates to the actions of investors/speculators that were such a big factor in the single-family and condo markets last year. Indeed, NAHB surveys of builders are documenting a falloff in investor purchases, rising sales cancellations by investors/speculators and resales of units owned by investors/speculators as the prospects for price appreciation deteriorate.
These cancellations and resales are adding supply to markets already experiencing an inventory run-up as demand cools in the face of deteriorating affordability conditions. Stay tuned.
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 May 3 edition. To subcribe to “Eye on the Economy,” click here.
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Seiders Says, 'Builders Have Not Lost Touch With Demand' on the NAHB Economics Blog
NAHB Chief Economist David Seiders says that "builders have not lost touch with demand" 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 Seiders' expert opinions, projections and responses. Then let Seiders know what you think by giving your perspective.
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