Eye on the Economy
By David F. Seiders, NAHB Chief Economist
Data revisions brighten the near-term outlook for economic growth …
The Commerce Department’s “final” estimate of growth in real gross domestic product (GDP) for the fourth quarter of 2004 stands at 3.8%, the same as the preliminary estimate. Thus, growth for all of 2004 stands at 4.4% on a year-over-year basis and 3.9% on a fourth-quarter to fourth-quarter basis. That makes 2004 the strongest year of the current expansion and easily an above-trend performance with positive implications for the labor market.
Although the recent revision did not affect the overall GDP growth rate, there were some compositional shifts that bode well for early 2004 and the near-term outlook. All the components of business fixed investment were revised upward — including residential fixed investment and spending on nonresidential structures as well as equipment and software ― and exports also were boosted a bit. Offsetting downward revisions were made to government spending (federal, state and local) and to business inventory investment. The latter revision definitely brightens the GDP outlook for early 2005 by bolstering the prospects for more inventory accumulation in the early months of this year.
NAHB’s forecast now shows stronger growth in the first half of 2005 …
Incoming data signal a strong rate of GDP growth in the first quarter. As expected, business inventory investment surged in January and other monthly indicators show strength through February. Home sales, housing starts and residential construction put-in-place were quite good, and retail sales, personal consumption expenditures and durable goods orders show solid spending by consumers and businesses. Data on shipments and orders for durable goods in early 2005 are particularly encouraging, since the expiration of tax incentives for capital investment at the end of 2004 had raised the prospect of a temporary shortfall in business outlays.
The forward momentum of key monthly indicators has prompted upward revisions to NAHB’s forecast for GDP growth in both the first and second quarters of this year — from 4.0% and 3.9% to 4.5% and 4.2%, respectively. These forecast revisions raise year-over-year GDP growth to 4.0% in 2005, and we’re still looking for 3.6% growth in 2006 as the economy converges toward sustainable long-term trend growth.
The job market continues to expand despite mixed signals and the productivity factor …
The employment report for March was released on April 1, provoking cries of “April fool” in financial markets. Contrary to market expectations, payroll job growth was revised downward for both January and February and the preliminary estimate for March (110,000) was surprisingly weak. On the other hand, the unemployment rate fell by a larger-than-expected amount (from 5.4% to 5.2% ) as total employment from the household survey surged by 357,000 and unemployment fell by nearly that amount (the labor force was virtually unchanged).
So is the labor market improving or deteriorating? The weight of evidence points toward ongoing improvement, and it’s worth remembering that the payroll employment numbers show a lot of month-to-month volatility and are subject to sizeable revision.
Having said that, productivity growth is a somewhat mysterious “wedge” between growth of economic output (GDP) and growth of employment, and it’s entirely possible that productivity growth rebounded in the first quarter following a slowdown in the second half of last year.
Declining slack in labor markets threatens upward cost pressures …
We’re sticking with our previous estimate of payroll job growth in 2005, despite the surprisingly low numbers for the first quarter (a monthly average of 160,000). We’re showing an average of nearly 200,000 for the year as a whole, recognizing that productivity growth could make that difficult to achieve.
The sudden drop of the unemployment rate in March, along with stubborn stability of the labor force participation rate at a surprisingly low level, suggest serious reduction in the degree of slack in the U.S. labor market. That issue, in turn, raises serious questions about the amount of above-trend GDP growth that the economy can continue to generate with only modest upward pressures on unit labor costs and core inflation. The data on average hourly earnings in the March employment report were reassuring in this regard, but even a gradually tightening labor market will keep this issue in focus as we move ahead.
Core inflation is gathering momentum as the economic expansion rolls along …
The core producer price index (PPI) for finished goods posted a year-over-year advance of 2.8% in February, the biggest 12-month increase in more than a decade and definitely an unsettling inflation signal. The core consumer price index (CPI) showed a 2.4% year-over-year advance in February, and the technically superior chain-core CPI posted a 2.0% gain. These readings also were on the high side of recent experience and contributed to the thickening inflation plot.
The core price index for personal consumption expenditures (PCE), the Fed’s favorite inflation gauge, registered a 1.7% year-over-year gain in February, and the market-based version (excluding various implicit prices) was up by 1.6%. These rates certainly don’t look alarming, but it’s worth remembering that the upper bounds of core PCE inflation projections by members of the Federal Open Market Committee (FOMC) presented to Congress in mid-February stood at 1.75% for both 2005 and 2006 (fourth-quarter to fourth-quarter basis).
Year-over-year core PCE inflation (1.7%) already is near the upper bound of the FOMC’s projected ranges, which presumably represent FOMC targets, and upward inflation pressures now are gathering rather than dissipating. Indeed, the annualized six-month, three-month and one-month changes in the core PCE price index now stand at 2.0%, 2.0% and 2.3%, respectively, definitely a pattern of gathering momentum.
The Fed hikes rates again and fusses about inflation pressures …
As expected, the Fed enacted another quarter-point increase in its federal funds rate target at the March 22 meeting of the FOMC. This adjustment took the funds rate to 2.75%, up from 1.0% at mid-2004 when the Fed started to remove monetary policy “accommodation” from the economy.
The FOMC statement of March 22 once again specified that remaining policy accommodation can be removed “at a pace that is likely to be measured.” However, the statement noted that “pressures on inflation have picked up in recent months and pricing power is more evident.” The statement also revealed some concern about potential upward pressures on core consumer price inflation from the rise in energy prices.
The FOMC’s assessments of the current economic situation as well as the risks to the economic expansion also were altered on March 22. The statement upgraded the assessment of recent economic growth from “moderate” to “solid” while continuing to say that “labor market conditions continue to improve gradually” ― an assessment consistent with the labor market report for March. With respect to the risk profile, the FOMC now says that “appropriate monetary policy action” will be needed to maintain an even balance of risks to sustainable economic growth and price stability, and the committee’s confidence in the balanced risk profile evidently is eroding as core inflation firms up.
More rate increases are in store as the Fed seeks out monetary ‘neutrality’ …
Another quarter-point increase in the funds rate target is highly likely at the next FOMC meeting on May 3 (the March employment report reduced the risks of a half-point increase at that time). We now expect the funds rate target to be 4.0% at year end, and that monetary policy process will raise the bank prime to 7.0%.
It’s difficult to pinpoint the federal funds rate that the Fed considers “neutral,” partly because the neutral rate is data-dependent. The Fed thinks in terms of the “real” (inflation-adjusted) funds rate, and we’re assuming that a real rate of 2.25%-2.50% will be required to achieve neutrality. Until fairly recently, the real federal funds rate actually was negative.
Fed Chairman Alan Greenspan presumably will want to shepherd monetary policy into a neutral zone as his term as Fed governor draws to a close early next year, and our forecast shows a nominal funds rate of 4.25% by early 2006. It remains to be seen whether or not the Fed will go on hold at that point. Everything depends on the evolving balance of economic growth and inflation and the priorities of the incoming chairman.
The Fed successfully talks up long-term interest rates …
The Fed has direct control over only very short-term interest rates and relies heavily on communications to influence longer-term rates. The Fed definitely has “talked up” long-term rates since mid-February. At that time, Greenspan told the Congress that declining long-term rates and a distinct flattening of the yield structure posed a “conundrum” in U.S. and global financial markets. Not only was Greenspan hard-pressed to explain the behavior of long-term rates since mid-2004 when the Fed started to hike short-term rates (quite an admission by the Fed chairman) but he also appeared dissatisfied with the refusal of long rates to move up. The markets read this message as a heads-up concerning future monetary policy moves, and long-term rates shifted upward immediately.
Greenspan’s mid-February comments clearly had an effect on bond market psychology, and the March 22 FOMC statement strengthened the message. Yields on both 10-year Treasury bonds and fixed-rate home mortgages moved up by roughly 50 basis points through the end of March, and these long-term rates still are within NAHB’s forecasts range despite a bond market rally provoked by the unexpectedly weak payroll employment report for March. We’re expecting additional half-point increases in both Treasury bond and mortgage rates over the balance of the year, moves that would take these measures to 5.0% and 6.5%, respectively, in the fourth quarter of the year. We’re currently showing additional half-point increases over the course of 2006.
Housing market activity surges in the first quarter of 2005 …
Housing starts for January have been revised upward and the preliminary estimate for February showed another increase — to a 21-year high for total starts and an all-time high for the single-family component. The multifamily sector also posted robust numbers for the January-February period, apparently driven by a strong condo component as well as an improving rental market.
Issuance of building permits was robust in the first two months of the year (both single-family and multifamily), and a sizeable backlog of unused permits at the end of February bodes well for housing starts in March. Sales of both new and existing homes also were quite solid for the January-February period, showing only modest declines from the record numbers posted in the final quarter of 2004, and single-family construction put-in-place showed solid gains in the first two months of the year.
Surveys of both home builders and mortgage lenders confirm ongoing strength of demand in the single-family sector through March. NAHB’s Housing Market Index held at the elevated level of February (69) and weekly data on applications for mortgages to buy homes (Mortgage Bankers Association series) conform to the pattern of high and reasonably stable market activity.
The strength of housing data for the early part of the year has prompted upward revisions to NAHB’s estimates of housing starts and home sales for the first quarter. We’re now showing total housing starts at an annual rate of 2.14 million units, the peak quarter for the expansion, and the single-family component stands at 1.77 million ― easily a record pace. The projected upswing in starts drives our estimate of annualized first-quarter growth in residential fixed investment to 14.2%, compared with 9.7% for 2004 as a whole.
The housing outlook remains bright despite mounting complications …
Much of the first-quarter strength in housing market activity occurred before the recent upshift in long-term interest rates, and further increases in the entire interest rate structure are in the cards as we move ahead. The inevitable interest-rate drag on housing demand will be largely offset by ongoing growth in employment and household income, particularly in 2005, although the net effect of all these factors most likely will be more negative by 2006.
A second complication in the housing outlook relates to an apparent surge in home buying by investors/speculators, financed to some degree by highly aggressive mortgage instruments — such as low-documentation, interest-only, adjustable-rate mortgages with deeply discounted initial rates. It’s not clear how much of the recent record levels of home sales and single-family housing starts reflects investor/speculator efforts to garner quick capital gains, and to what degree the homes they bought are poised to come back onto the market at the first hint of price weakness. The same questions apply to the surging condo market.
NAHB is canvassing builders and local home builders associations about the investor/speculator phenomenon, and we’ll be reassessing the implications of the investor/speculator phenomenon for the housing markets down the line. For now, we’ve retained forecasts for home sales and housing starts that show only slight erosion in 2005, followed by more significant slippage in 2006 as the interest rate upswing exerts more influence and job growth loses some momentum. In this forecast, growth of residential fixed investment finally slips into the red zone by the second quarter of this year.
The home equity ‘buffer’ may or may not be needed …
The recent acceleration of house price growth, particularly in hot metro markets along the coastlines, may very well reflect aggressive buying by investors/speculators seeking quick capital gains. If so, price levels in those areas are vulnerable to a bailout by investors, and subsequent price declines conceivably could erode home owner equity, weaken the quality of home mortgages and threaten the health of mortgage investors as well as mortgage insurers. Bank regulators and the private mortgage insurance industry are fully attuned to the dangers.
Greenspan discussed this potential problem on Capitol Hill in mid-February. While conceding that house prices exhibit “bubble” characteristics in some local areas, Greenspan argued against a national house price bubble and downplayed the consequences of potential price declines in vulnerable local markets.
Greenspan pointed out that past price increases in high-froth markets had created large home equity “buffers” that would protect most home owners (and mortgage investors/insurers) in the event of price reversals. Indeed, the Fed’s national balance sheets show a record $9.6 trillion in housing equity at the end of 2004, despite rapid growth of home mortgage debt in recent years, and the overall debt-to-value ratio is only 44% ― the same as a year earlier. This doesn’t mean that all home owners are protected, but the huge equity buffer certainly would limit the damage wrought by potential price reversals in local markets.
Oil prices once again threaten the outlook for housing and the economy …
Global oil prices hit a record high last October ($56.37 for WTI) and then receded quite a bit in the following months (to $40.71 in early December). But oil prices surged again in February and March and recently rose above the records of last fall.
This unanticipated resurgence, if not reversed in short order, could weaken economic growth and infect core consumer inflation rates over time, threatening a demoralizing “stagflation” process that the Fed would be hard-pressed to counter. Such an outcome definitely would be negative for the housing sector.
We currently believe that the fundamentals of global supply and demand will shepherd oil prices downward from recent record levels. Global oil prices are subject to a host of uncertainties, of course, and it’s fair to say that oil will remain a wild card for some time to come.
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 April 6 edition. To subcribe to “Eye on the Economy,” click here.
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