The economy and financial markets are pushing the Fed down the path to monetary ‘neutrality’…
The impressive employment reports for March, April and May — coupled with the systematic pickup in core inflation signaled by the PPI, the CPI and the PCE price indices — have increased the chances for a near-term rate increase by the Fed. Furthermore, recent public statements by various Fed spokespersons show that the central bank definitely is leaning in that direction.
There’s still a high probability of a quarter-point increase in the federal funds rate target at the next Federal Open Market Committee (FOMC) meeting on June 30, and that presumption is now incorporated in NAHB’s forecast. We’re also assuming quarter-point increases at the Aug. 10 and Nov. 10 meetings, bringing the funds rate up to 1.75% for the balance of the year.
The Fed presumably is planning to move the federal funds rate to a “neutral” position that neither stimulates nor impedes growth of the economy. Neutrality should be around 4% on a nominal basis and 2% in real (inflation-adjusted) terms. We currently assume that the Fed’s march to neutrality will take nearly two years, but the speed of adjustment will be heavily influenced by the actual path of core inflation.
Core inflation is not likely to break out of the Fed’s range of acceptability …
Looking ahead, the big question is: will core inflation break out of the Fed’s range of acceptability and force the entire yield structure higher and higher? One school of thought says that a near-term breakout is inevitable as the economic expansion proceeds and the job market tightens. Another insists that the recent pickup in core inflation (particularly the core CPI) contains some temporary factors and that ongoing strength in growth of labor productivity will continue to hold down unit labor costs and allow the expansion to proceed with minimal inflationary pressure. A firming dollar on the foreign exchange markets also supports the low-inflation case.
NAHB’s forecast leans toward the second school of thought. We believe that current long-term rates reflect realistic inflation expectations as well as realistic assessments of future Fed policy. That said, history shows rather clearly that Fed tightening, once it begins, causes long-term rates to move up by at least a fraction of the increase in short-term rates as liquidity is withdrawn from the financial system. Our forecast shows a percentage-point increase in long-term rates in the context of a 2.5 percentage point increase in the federal funds rate between mid-2004 and late-2005.
This round of Fed tightening is not intended to squash housing and the economy …
A tightening process by the Fed ordinarily begins when the economy is overheating after a long economic expansion and when upward pressures on inflation definitely are serious. This time, the economy still has a lot of slack in the labor and capital markets, we’re coming off a period of dangerously low inflation and the Fed is moving off an extraordinarily stimulative monetary policy stance that was designed as defense against potentially destructive deflation in the U.S. economy. This emergency stance has involved a federal funds rate of only 1%, a rate that actually became negative in real terms when inflation began to edge up early this year.
Federal Reserve tightening in the late '70s, late '80s and 2000 amounted to hitting the policy brakes, as did a rather frightening episode in 1994 when the Fed believed the economic recovery was gaining too much forward momentum. In the present case, the Fed will be gradually lifting the accelerator off the floor rather than hitting the brakes, seeking to shepherd the evolving economic expansion into a self-sustaining trend characterized by a low and stable unemployment rate as well as low and stable inflation.
Low inflation is as good as gold for home builders …
Maintenance of low inflation is critical to the housing industry since long-term interest rates are highly sensitive to inflation. Thus, builders actually should appreciate the Fed’s march back toward a neutral monetary policy position, even though higher short-term rates raise the cost of credit for construction and land development, since the effort should pay dividends in terms of long-term mortgage rates.
If the Fed is successful, builders can look forward to strong housing demand for many years. Recent NAHB analysis of long-term trends shows that demographics, replacement requirements and other fundamentals should support production of nearly 1.5 million single-family homes per year, on average, during the 2004-2013 period. That, by the way, is up to 2003 standards when single-family starts hit a record high.
House values continue to post solid gains in both nominal and real (inflation-adjusted) terms …
Home sales and housing production have remained quite strong so far this year, and house prices have continued to far outpace broad measures of inflation in prices of goods and services. The repeat-sales House Price Index (HPI) produced by the Office of Federal Housing Enterprise Oversight (OFHEO) posted a 7.7% year-over-year advance in the first quarter, in the range of increases seen during the past three years, and all the states and major metro areas posted positive changes. Furthermore, the median price of existing homes sold rose at a 7.3% pace in April.
Now that the job market is truly in gear in most places and the threat of overall price deflation is behind us, bursting house price “bubbles” is becoming quite a distant prospect. A major study first completed by NAHB and other members of the Homeownership Alliance projects national home price increases in the range of 5%-6% in coming years.
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 June 2 edition. To subcribe to “Eye on the Economy,” click here.
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