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Eye on the Economy
By David F. Seiders, NAHB Chief Economist
The economy still is moving ahead at a solid pace …
Earlier fears of a stall out in growth of the U.S. economy have been erased by revisions to key data for the first quarter, as well as by reassuring data for April and May.
As expected, growth of real Gross Domestic Product (GDP) was revised up for the first quarter, from 3.1% to 3.5%. The revision reflected stronger patterns for personal consumption expenditures, residential fixed investment and foreign trade, while business inventory investment was revised downward (that’s a good thing). The performance of GDP growth squares with the solid performance of the labor market in the first quarter.
Forward economic momentum extended into the second quarter of the year. Growth of personal consumption expenditures remained quite healthy in April, supported by strong growth in disposable personal income (particularly labor income). Expenditures on housing also continued to climb in April as home sales surged and residential construction put-in-place recorded another solid advance, and surveys of builders and mortgage lenders were quite positive in May. New orders for durable goods were revised up for March and perked up in April, and the Institute for Supply Management’s factory index remained above 50 in May — suggesting that the manufacturing sector still is in a forward gear. Everything considered, GDP growth appears to be headed to about 3.5% in the second quarter, and we expect growth to hang around that pace in the second half of the year.
Oil and gas prices sag and ‘core’ inflation looks benign …
Global oil prices and the cost of gasoline at the pump have come off their April highs, reducing threats to the ongoing economic expansion as well as threats to “core” inflation (excluding prices of food and energy) in the U.S. Inevitable “leakage” of oil and gas prices into core consumer prices has been on the minds of officials at our central bank, and the recent sag of energy prices certainly is welcome news.
The news on core consumer price inflation in April was reassuring in its own right. The year-over-year change in the core component of the Consumer Price Index (CPI) receded to 2.2% while the technically superior chain-core version held at a 1.9% pace. Of even more importance, the Fed’s favorite inflation gauge — the core price index for Personal Consumption Expenditures (PCE) — receded to 1.6% in April (year-over-year basis) and the market-based version (excluding various implicit prices) was exactly the same. While the core PCE price measures remain near the upper end of the Fed’s apparent “comfort zone,” the recent lack of upward momentum is a major change in the economic environment.
The Fed is poised to hike short-term rates again …
Minutes from the May 3 meeting of the Federal Open Market Committee (FOMC) reveal ongoing preoccupation with upside risks to the inflation outlook as the economic expansion moves forward and slack in resource markets is reduced in the process. The minutes also make it perfectly clear that the Fed still views its monetary policy stance as too easy, despite the substantial increase in the federal funds rate implemented since mid-2004 (two percentage points). Indeed, the minutes say that all FOMC members “regarded the stance of monetary policy as accommodative and judged that the current level of short-term rates remained too low to be consistent with sustainable growth and stable prices in the long run.” Indeed, the real (inflation-adjusted) funds rate is only about 1%, and history shows that such a policy stance is not sustainable over time.
The evaporation of the early-year “soft spot” in the economic expansion gives the Fed leeway to accelerate its march back to monetary “neutrality,” while the recent positive news on core inflation lessens the urgency of such a march. NAHB’s forecast assumes the Fed will continue to move ahead at a determined but “measured” pace, hiking the funds rate by another quarter point (to 3.25%) at the June 30 FOMC meeting and taking this short-term rate to 4% by year end. Some further increase may be in the cards for 2006.
Long-term interest rates continue to move downward …
Long-term interest rates have moved downward in recent weeks, pushing the 10-year Treasury yield below 4% and the fixed-rate home mortgage yield to about 5.5%. These rates are lower than in early February when Fed Chairman Alan Greenspan told Congress that persistently low long-term rates posed a “conundrum” in U.S. and global financial markets.
The evolving patterns of GDP growth and core inflation clearly are viewed as positive by bond market participants, and the Fed’s revealed preferences about monetary policy management certainly are helping to contain long-term inflation expectations — perhaps the biggest influence on current long-term interest rates. The U.S. also is enjoying a large inflow of foreign capital into U.S. financial markets, and a lot of it is coming from foreign central banks.
It’s entirely possible that current downward pressures on long-term interest rates will persist as the economic expansion moves forward. But it’s more likely that the expansion will generate stronger upward pressures on core inflation (primarily from rising unit labor costs) and that ongoing Fed tightening ultimately will push short- and long-term rates in the same direction. NAHB’s forecast currently shows roughly half-point increases in long-term rates by late in the year — half the projected increase in the federal funds rate.
Housing market activity continues to strengthen …
The recent economic and financial market environment has been quite hospitable for the housing sector, and a spate of highly aggressive mortgage finance products has supported housing demand in markets where affordability has been strained by rapid increases in house prices. Indeed, the interest-sensitive housing sector has remained the hottest part of the U.S. economy despite the pattern of Fed tightening since mid-2004.
Upbeat news on housing for April includes record levels of both new and existing home sales, yet another housing starts number on the north side of 2 million units, and another solid increase in construction put-in-place. Indeed, year-to-date readings are up substantially for sales, starts and construction activity, and the 2004 single-family records clearly are in jeopardy. NAHB’s first-quarter Multifamily and Remodeling Market Indexes (based on surveys of apartment producers and managers as well as professional remodelers) show that these housing components are moving ahead nicely as well, and patterns of construction spending through April show great strength in these areas.
Surveys of builders and mortgage lenders show that robust housing market activity extended into May. NAHB’s Housing Market Index (based on surveys of single-family builders) edged up to 70 in May, near the top of the range that’s prevailed for more than a year. Furthermore, the index of applications for mortgages to buy homes (Mortgage Bankers Association series) moved up to a record level by late May (four-week moving average).
House price increases fuel widespread ‘bubble’ concerns …
The most reliable indicator of house price movements in the U.S., the House Price Index produced by the Office of Federal Housing Enterprise Oversight (OFHEO), has been released with price readings for the first quarter of the year. Excluding refinancing activity, OFHEO’s repeat-sales House Price Index was up by 10.26% on a year-over-year basis, off only marginally from the pace of late 2004. Including refinancing “transactions” (and appraisals behind the refinancings), the House Price Index was up a whopping 12.5% on a year-over-year basis.
The minutes from the May 3 FOMC meeting noted that “house prices continued to rise rapidly over the first quarter,” while contending that “recent data suggested some slowing.” But it turns out that the second-best measure of house price change, the median sales price of existing homes sold (from the National Association of Realtors®), actually accelerated in April (data released on May 24). Indeed, the median price of single-family homes was up by 15.1% on a year-over-year basis, and the median price for condos/co-ops was up by 18.4%.
The sustained rapid acceleration of house prices inevitably has generated a flood of charges regarding dangerous “bubbles” in U.S. housing markets. Indeed, even Greenspan has changed his tune, recently acknowledging that house prices show signs of “froth” and saying that price behavior exhibits an “unsustainable underlying pattern.” While remaining skeptical about a national house price bubble, Greenspan said there were signs of “lots of little bubbles” (i.e., froth) in particular markets.
But house price ‘busts’ do not necessarily follow price ‘booms’ in local markets …
Housing markets are not nearly as susceptible as securities markets to boom-bust patterns, but history clearly shows that house prices can fall substantially in local markets if something really goes wrong. On this point, a recent study by the Federal Deposit Insurance Corporation (FDIC) entitled “U.S. Home Prices: Does Bust Always Follow Boom?,” offers some useful perspectives.
The FDIC study noted that metro-area house price booms don’t last forever, that price booms do not necessarily lead to price busts and that most past booms have ended in periods of house price stagnation that allowed various economic fundamentals (including household income and housing supply) to catch up. In this regard, most recorded house price busts were preceded by significant stress in local economies (not vice versa).
This time could be different, of course, and current “bubble” charges focus heavily on an unusually heavy presence of investors/speculators in boom markets as well as on a glaring prevalence of “innovative” mortgage products that stretch affordability but may sacrifice credit quality down the line. But as long as the national economy continues to move ahead nicely, pulling most local economies with it, the most likely outcome will be a slowdown (or flattening) of house prices in overheated areas, with few cases of outright decline.
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 1 edition. To subcribe to “Eye on the Economy,” click here.
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