Eye on the Economy: Housing Pulls Down Economic Growth
The three-year “benchmark” revision to the national economic accounts, released by the Commerce Department on July 28, trimmed growth of real gross domestic product (GDP) and labor productivity while raising core inflation ― a sobering package of adjustments. Furthermore, the “advance” estimate of GDP for the second quarter of this year (released at the same time) showed below-trend 2.5% annualized GDP growth, modestly below our expectations.
The benchmark GDP revision substantially altered the path of real residential fixed investment (RFI), showing even stronger growth in the first half of last year but swinging RFI growth from positive to negative in both the fourth quarter of 2005 and the first quarter of this year. In addition, the advance GDP report for the second quarter shows a hefty contraction in RFI, a reduction that lopped a sizeable piece off the GDP growth rate.
Thus, the revised and updated GDP numbers clearly show that the housing sector was a major part of the above-trend economic growth pattern through the third quarter of 2005 and that housing is largely responsible for the shift to below-trend economic growth that’s now underway.
The Labor Market Also Is Weakening as the Economy Slows
The U.S. labor market inevitably has lost strength as GDP growth has slipped below trend. Payroll employment increased by only 113,000 in July, equal to the average gain for the past four months and equivalent to an annualized growth rate of only 1% ― down from an average 1.5% pace during the previous five quarters. Employment in home building fell by 9,000 in July and is off by 37,000 from its cyclical peak in March.
The unemployment rate increased by 0.2% in July, from a cyclical low of 4.6% in June, and the pool of available labor moved upward despite a stubbornly low labor force participation rate. Despite the weakening of labor market conditions, average hourly earnings posted year-over-year growth of 3.8% in July, the same as in June and a growing complication on the inflation front.
Core Inflation Accelerates, But the Fed Remains Calm
Measures of core consumer price inflation have been accelerating recently, despite the downshift in GDP growth and the weakening of labor market conditions. The core consumer price index (CPI) posted a year-over-year advance of 2.6% in June and the core price index for personal consumption expenditures (PCE), the Fed’s preferred inflation gauge, showed a 2.4% year-over-year advance.
These inflation readings look quite troublesome when the Federal Reserve apparently wants to limit year-over-year changes in the core CPI and PCE price indexes to 2.5% and 2.0%, respectively.
Fed Chairman Ben Bernanke delivered a surprisingly friendly message on the inflation situation during his July 19-20 semiannual Monetary Policy Report to the Congress. While citing the pickup in core inflation this year, Bernanke felt that upward price pressures would subside in coming months as long as oil prices stabilize near current record levels and economic growth remains below trend. He also emphasized that the Fed must consider the lagged effects of past policy changes when making future policy decisions.
Finally, under questioning stimulated by NAHB’s communications with Congress, Bernanke seemed to agree that recent upward pressures on core inflation stemming from surges in “owners’ equivalent rent” are rather perverse from a policy perspective and can be discounted by the Fed.
The Housing Downswing Still Is Underway
Recent indicators show that housing still is on a downward path that should weigh on economic growth for a few more quarters. Indeed, measures of housing affordability continued to deteriorate through mid-year, sales of single-family homes and condo units have been falling, and both housing starts and building permits moved down further in June.
Available indicators for July suggest that the housing downswing still is underway. NAHB’s Housing Market Index slipped by three more points to a level of 39, down from a cyclical high of 72 in June 2005 and the lowest level since late 1991.
The weekly survey of lenders conducted by the Mortgage Bankers Association shows that, in July, applications for mortgages to buy homes were down from June and 20% below the cyclical high a year earlier.
NAHB surveys of large single-family home builders show that, because of soaring cancellations, net sales of new homes have fallen by a lot more than gross sales from the highs of last year. Inventories of new homes in the hands of builders actually are a lot larger than the record number being reported by the Commerce Department. Furthermore, the inventory of existing single-family homes was up by 36% in June (year-over-year) and the inventory of existing condo/co-op units was up by 63%.
The Fed Pauses and Bond Markets Rally
As we expected, the Fed held short-term interest rates steady at the Aug. 8 FOMC meeting, maintaining the 5.25% target for the federal funds rate. The FOMC statement cited the recent slowdown in economic growth, singling out the “cooling of the housing market.” The statement also said that “inflation pressures seem likely to moderate over time.”
The FOMC’s public statement stressed that future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth. The FOMC’s economic projections, revealed in the Fed’s recent Monetary Policy Report to the Congress, show expectations for slowing growth and receding core inflation, and NAHB’s current forecast goes even further in those directions.
If we (and the FOMC) turn out to be on target, the Fed should be able to hold policy steady for some time and possibly drop rates some time next year.
Long-term interest rates have been falling since late June as evidence of a slowing economy has accumulated and as Fed spokespersons, particularly Bernanke, have been remarkably sanguine about the prospects for core inflation.
The FOMC’s decision on Aug. 8, along with the rather even-handed public statement, maintained downward pressure on long rates — holding the 10-year Treasury yield below 5% and keeping the long-term home mortgage rate around 6.6%.
NAHB’s Forecast Still Tells a Fundamentally Positive Story
The wealth of recent information on housing and the economy has prompted a variety of changes to NAHB’s forecasts for the second half of this year and 2007. The basic story remains the same, although the economic slowdown is a bit more serious, the interest rate structure is a bit lower and the housing downswing is a bit deeper.
We continue to view the 2006-2007 slowdown as an inevitable mid-cycle correction that will pave the way for at least several more years of economic expansion and healthy trend-like housing market activity.
There are downside risks, of course, but recent developments in financial markets bolster our confidence in our baseline (most probable) outlook.
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 Aug. 9 edition. To subcribe to “Eye on the Economy,” click here.
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