It appears, however, that the surge in demand for economic output compelled the business sector to step up hiring during the latter part of the third quarter and into the final quarter of 2003. The Labor Department now reports that payroll employment grew by about 250,000 during the September-October period, and job growth continued in November.
The big question, of course, regards the future paths of output and productivity growth and the implications for the labor market. NAHB’s forecast shows slowdowns in both output and productivity growth from their robust third-quarter performances, with the balance of forces favoring moderate but systematic job growth over the rest of this year and in 2004. This pattern, if it materializes, certainly will be great news for the Bush Administration.
The improving job market, in turn, provokes increases in consumer confidence/sentiment …
The recent improvements in the labor market provoked sizeable recoveries in both consumer confidence (Conference Board) and consumer sentiment (University of Michigan) in November. Furthermore, both sources reported improvements in consumer assessments of both the current economic situation and the economic outlook, the first time that’s happened in quite a while. Thus, a majority of consumers may now believe the economic recession is truly over — two full years after economists declared an end to the 2001 recession.
Economic growth is subsiding in the fourth quarter, but forward momentum remains substantial …
Some of the key components of the third-quarter surge in GDP growth are bound to slow down. But it’s not true that the U.S. economy somehow used up all its capacity and is now slipping back into a sub-par growth pattern — as suggested by some pundits in the media as well as some practitioners of the dismal science of economics.
There’s no question that consumer spending was spurred in the third quarter by a jolt of stimulus from the new tax-cut bill that was implemented on July 1, and housing apparently received special stimulus as mortgage rates bounced off their cyclical lows and drew many “fence sitters” into the market. But spending by households is hardly going to fall apart, and we can look forward to positive performance by the nonresidential business sector, the government sector and the trade sector as special stimulus from tax cuts and interest rate shifts moves behind us.
Everything considered, GDP growth should be about 4% in the current quarter and hang around that pace in 2004. This kind of output growth, along with a slowdown in productivity growth (to about 2.5%), should generate average increases in payroll employment of nearly 200,000 per month over the next five quarters — leaving the job-losing phase of the recovery in its wake.
The nonresidential business sector remains the key to sustained economic expansion …
Spending by nonresidential businesses on inventories, capital equipment and structures fell substantially in the recession of 2001, and persistent weakness of these components has held back the recovery process — at least until quite recently. But some batons now are being passed, as spending by households is slowing to a more sustainable pace, imbalances in the business sector are being corrected and corporate profits are surging.
The third-quarter GDP report revealed strong growth (18.4%) in businesses spending on capital equipment and software, and it’s clear that this key component of the economy is on a real upswing — aided by the more favorable rules on depreciation and business expensing in this year’s tax bill. On the inventory front, businesses slowed the rate of liquidation in the third quarter. Sales ratios are now so low that an upswing in inventory investment is bound to begin in the fourth quarter and gain momentum next year. Spending by businesses on nonresidential structures contracted sharply in 2001 and 2002 but has been essentially flat during the past year. The flattening process has removed a major drag on GDP growth, and meaningful recovery is likely to commence around mid-2004.
The incredible process of cost-cutting and productivity growth seen in the U.S. business sector in recent years now is returning huge benefits in terms of profitability, stimulating the stock market and providing firms with expanding cash flows to fund spending. Indeed, economic profits (with inventory valuation and capital consumption adjustments) grew at an annual rate of 50% in the third quarter and were up by 30% on a year-over-year basis. This surge raised profits levels above the peaks of the late 1990s.
The deflationary threat may be receding as 'core' inflation rates stabilize …
The surge in productivity growth definitely has put further downward pressure on unit labor costs and inflation, while the surge in spending that has propelled real GDP growth presumably provided some support to prices of goods and services despite limited pricing power by U.S. businesses. As a result, core inflation measures (excluding food and energy) may now be stabilizing after major erosion that raised concerns about a destructive Japanese-style deflationary process in the U.S.
The core GDP price index posted a 1.3% annualized advance in the third quarter, following slippage to 0.6% in the second quarter, and the change in the core personal consumer expenditures (PCE) price index — a favorite of the Fed — rose from 1.1% to 1.7% over the same period. The monthly core PCE price index held at an annual rate of 1.3% in October, the same as the readings for August and September, and was up by 1.2% on a year-over-year basis. An alternative measure of core inflation, from the consumer price index (CPI), showed an annualized advance of 2.5% in October that translates to a 1.3% year-over-year advance, up a bit from the September pace.
It’s obviously hard to draw firm conclusions from the various measures of core inflation. Furthermore, the recent sharp declines in unit labor costs will be a price depressant going ahead, and well-known upward biases in the inflation measures mean that we’re actually closer to zero inflation than we may think. Thus, while the deflation scare seems to be receding in financial markets, the Fed certainly will continue to worry about it for some time.
The Federal Reserve is holding down the entire interest rate structure …
The Fed now is in a holding pattern, keeping the federal funds rate at 1% while enjoying the pickup in economic growth and waiting patiently for major improvement in the labor market and firming up of core inflation. The recent surge in GDP growth prompted some speculation in financial markets about a hike in the funds rate by early next year, but Chairman Alan Greenspan and other Fed spokespersons quickly threw cold water on that theory. As a result, long-term interest rates have been remarkably steady despite obvious improvements in the economy.
The Fed has plenty of time on its hands, and the central bank’s commitment to maintain the current “accommodative” monetary policy stance for a “considerable period” should not be taken lightly. Indeed, it will take quite some time to get core inflation up in the midst of a productivity wave, and productivity growth will continue to hold down hiring to some degree as well. Furthermore, the unemployment rate will be slow to fall since both the average length of the workweek and the labor-force participation rate will be moving up as the economic expansion proceeds.
The Fed certainly will not raise the funds rate until the deflation threat is behind us and the unemployment rate is well off its cyclical highs. NAHB’s current forecast shows the first rate increase at the Federal Open Market Committee (FOMC) meeting on Nov. 10, 2004 (right after the elections). The Fed will be sending messages regarding shifting risks well in advance of the first rate hike, of course, and the resultant shift in market expectations will put some upward pressure on long-term rates prior to the November FOMC. We expect long-term rates to gravitate upward by about 75 basis points over the next 12 months, mostly after the first quarter of 2004.
It’s noteworthy that Greenspan’s term as Fed chairman runs out on June 20 of next year, and his departure certainly would be unsettling to financial markets — right in the middle of a presidential election year. We’re assuming that President Bush will ask Greenspan to stay on as chairman until his term as Federal Reserve governor runs out in early 2006 and that Greenspan will accept. It’s also noteworthy that the annual rotation of Federal Reserve Bank presidents as voting members of the FOMC is likely to make the FOMC slightly less “hawkish” on inflation next year. Both of these developments are consistent with our monetary policy assumptions for 2004-2005.
Housing continues to make major contributions to GDP growth, 'vigorous' activity in store for 2004 …
The full percentage-point contribution of residential fixed investment to the third-quarter GDP growth rate reflected record sales of both new and existing homes, a surge in single-family housing starts to a record level, a pickup in multifamily starts that involved a surge in the condo component and a big increase in residential remodeling.
The frenetic third-quarter pace presumably involved a surge in demand provoked by the bounce of mortgage rates off their June lows, and there’s some evidence that the volume of market activity is cooling a bit in the fourth quarter. In this regard, sales of new and existing homes were off by 3.5% and 4.9%, respectively, in October and inventories of new homes for sale moved up modestly in the process. Furthermore, November surveys of both single-family builders and home mortgage lenders tend to confirm that home buying has eased off following the third-quarter surge.
The housing sector is sure to make another sizeable contribution to GDP growth in the fourth quarter, largely reflecting upward momentum in construction-put-in-place following the virtual explosion of housing starts during the June-October period. For 2004, we’re looking for “vigorous levels” of housing activity (to borrow a Greenspan phrase) that will keep sales and production close to the records of 2003 but that will not continue to propel GDP growth. For builders and suppliers, that pattern is just fine.
House prices keep rising at a healthy pace, countering lingering concerns about price bubbles …
Average home prices increased by 6.61% in the third quarter on a year-over-year basis (OFHEO House Price Index), continuing the process of gradual deceleration from the peak rates of increase recorded in the first half of 2001. Furthermore, the rate of price increase picked up on a quarter-to-quarter basis (to 5.56%), suggesting that house price inflation in the U.S. is stabilizing in the 5%-6% range.
All nine Census Divisions and all the states recorded house price increases in the third quarter (year-over-year or quarter-to-quarter basis). Furthermore, virtually all major metro areas posted year-over-year gains in excess of 1% (San Jose, CA, and Austin, TX, were the only exceptions).
Despite the healthy performance of house prices, theories of house price bubbles continue to appear in the financial media. Now that the economic expansion has shifted into a higher gear, pulling the job market into the recovery process, house price bubble theorists have shifted their attention to prospective impacts of rising interest rates on house values. But these theories hold little water, for two fundamental reasons:
- Increases in mortgage interest rates (fixed-rate or adjustable-rate contracts) will be limited by Fed policy and low general inflation.
- Job growth and household income growth will be accelerating as interest rates gravitate upward.
Furthermore, tightening constraints on the supply of land available for residential development will continue to put upward pressure on construction costs and house prices.
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 Dec. 3 edition. To subcribe to “Eye on the Economy,” click here.
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