Eye on the Economy
By David F. Seiders, NAHB Chief Economist
The economy gains strength despite surging energy costs …
The economic expansion has been quite good for more than two years, and growth in real gross domestic product (GDP) stands at 3.6% for the first half of this year — an above-trend pace with positive implications for the labor market.
It now appears that GDP growth for the second quarter of this year will be revised upward, and the third quarter is shaping up to be truly robust (we’re currently estimating 4.4% growth).
The anticipated third-quarter GDP growth surge largely reflects a temporary rebound in business inventory investment, but there’s enough momentum in real final demand to keep GDP going nicely in the final quarter of 2005 and into 2006. The housing production component of GDP (residential fixed investment) has been a pillar of strength for several years, but housing should pass the growth baton to other sectors of the economy before long.
Above-trend GDP growth continues to tighten labor markets …
The strength of spending and economic output has generated systematic growth in payroll employment during the past two years despite historically high rates of growth in labor productivity (output per hour). Employment growth, in turn, has systematically lowered the nation’s unemployment rate despite ongoing growth of the labor force. This rate was 5% in July, compared with the cyclical high of 6.3% at mid-2003.
Strong employment growth and a falling unemployment rate obviously are positive developments in the economy. Tightening labor market conditions also have spawned increases in average hourly earnings — great for workers but a negative for the cost structure of American businesses and an inflationary impulse for our central bank to consider.
Various measures of labor cost have been throwing off mixed signals recently, but it’s obvious that slack in labor markets is being reduced, that growth of labor productivity has been slowing, and that rising labor cost per unit of output is a growing complication on the inflation front.
Core inflation apparently stabilizes despite rising labor costs and surging energy prices …
Recent signals on core inflation (excluding prices of food and energy) have been mixed. Rather alarming messages came from the core component of the Producer Price Index (PPI) which was up by 2.7% in July on a year-over-year basis. But the core component of the Consumer Price Index (CPI) showed an increase of only 2.1%, up a tad from the June pace but below rates recorded earlier in the year. Furthermore, the technically superior chain-core CPI showed a year-over-year advance of only 1.8% in July, the same as in May and June and below the January-April pace.
Everything considered, it’s fair to say that core inflation has stabilized recently at a pace that’s well above the rock-bottom rates of late 2003 but a bit below the troubling rates of early 2004. And while the recent readings on core consumer price inflation are not far below the upper end of the Federal Reserve’s implicit “comfort zone,” there’s no reason for the Fed to tighten monetary policy aggressively at this time. There’s also little reason for the Fed to stop tightening while the economic expansion is eating up slack in the labor market.
The Fed will continue to hike short-term rates at a ‘measured’ pace …
The Federal Reserve hiked short-term rates by 25 basis points at the conclusion of the Aug. 9 meeting of the Federal Open Market Committee (FOMC), the 10th consecutive quarter-point adjustment since mid-2004. This process has raised the federal funds rate target to 3.5% and pushed the bank prime rate to 6.5%.
The FOMC continued to describe monetary policy as “accommodative” (even after the Aug. 9 adjustment) and suggested that upward rate adjustments will continue “at a measured pace.” The FOMC’s assessment of recent economic activity, as well as its reading of the risks to the near-term outlook, reinforced the Fed’s concerns about core inflation down the line and highlighted the Fed’s “obligation to maintain price stability.”
The ongoing strength of the overall economic expansion ― including the stubborn strength of the interest-sensitive housing sector ― will encourage the Fed to enact quarter-point increases in the funds rate target at every FOMC meeting until monetary “neutrality” is achieved, and the Fed may even move monetary policy to a restrictive position during 2006.
We’re now assuming that the Fed will raise the federal funds rate to 4.25% by the end of this year and to a high of 4.5% at the conclusion of the Jan. 31-Feb. 1 FOMC meeting — a level that presumably will meet the Fed’s neutrality conditions. Alan Greenspan’s term at the Fed chairman officially ends on Jan. 31, but it’s likely he will still occupy the chair at the conclusion of the FOMC meeting — making the move to 4.5% part of his legacy.
Greenspan’s successor has not yet been nominated by President Bush, but Ben Bernanke appears to be the front runner. Bernanke was on the Federal Reserve board prior to acceptance of a recent appointment as chairman of President Bush’s Council of Economic Advisors. Management of monetary policy presumably would not change dramatically under Bernanke’s chairmanship, and his most recent comments on housing suggests that house prices would not become an explicit target of monetary policy.
Defiantly low long-term rates will gravitate upward after all …
The Federal Reserve obviously has been frustrated by the refusal of long-term interest rates to rise during the period of monetary tightening that began at the middle of last year. Indeed, long-term bond and mortgage rates are down, on balance, since then despite the cumulative 2.5 percentage point increase in the federal funds rate.
Greenspan recently told Congress that the Fed now understands the unprecedented behavior of long-term rates (i.e., it’s no longer a “conundrum”), but his explanations hardly provided a forecasting tool.
In any case, we’re still bravely assuming that the further tightening of monetary policy that we’re projecting, along with growing concerns in bond markets about firming inflation fundamentals, will move long rates upward over the balance of this year and in 2006.
We’re currently assuming that Treasury bond yields and long-term mortgage rates will move up by about 25 basis points as of the end of 2005 and by another 50 basis points by mid-2006. These increases, if they materialize, will forestall the much-feared inversion of the Treasury yield curve (short rates above longs) as the Fed marches onward. Stay tuned.
Housing market activity holds around second-quarter records …
Most measures of housing market activity hit record highs during the second quarter of this year. Highs were struck for sales of single-family homes and condo/co-op units and for issuance of single-family building permits. Starts of single-family homes hovered around a record pace (1.7 million) as did total housing starts (over 2 million units). In the process, residential fixed investment climbed to a new record high in the second-quarter GDP accounts.
Housing market indicators since mid-year are a bit of a mixed bag. Total housing starts for July were right on the second-quarter average as the single-family component edged up and multifamily receded, but issuance of building permits rose in both components of the market and the backlog of unused permits held near a record high. Sales of existing single-family homes and condo/co-op units (based on closings) were down modestly in July from records posted in June, while the Commerce Department reported that sales of new homes (based on contracts signed) hit a new monthly high in July. This report is subject to a high degree of statistical variability as well as to substantial revision, however, particularly on a regional basis.
Cutting-edge surveys of home builders and mortgage lenders, conducted in August, are consistent with the perception of historically high but flattening single-family housing market activity. NAHB’s Housing Market Index (HMI) for August was down by five points from the cyclical high in June as modest deterioration occurred in all three components of the HMI — buyer traffic, current sales and expected sales. The index of applications for mortgages to buy homes (Mortgage Bankers Association series) essentially rattled sideways around a record level during July and the first three weeks of August (four-week moving average basis).
House price appreciation rates may be topping out …
The rate of appreciation in home prices was quite strong in the second quarter as sales of single-family homes and condo/co-op units surged to record levels. Indeed, Fannie Mae’s analysis of its own portfolio data suggests that OFHEO’s benchmark House Price Index for home purchases (excluding refinancings) is likely to accelerate to about a 14% year-over-year gain in the second quarter (OFHEO data will be released on September 1). Furthermore, the median prices of existing single-family homes and condo/co-op units sold in June were up by 14.5% and 14.8%, respectively, on a year-over-year basis.
House price increases still are quite strong but the rates of acceleration may be topping out. The median prices of existing single-family and condo co-op units sold in July were up by 14.6% and 11.3%, respectively, on a year-over-year basis, and a buildup in the inventories of units for sale may hold down price appreciation in coming months — particularly in the condo market.
A ‘soft landing’ for housing still is the best bet …
In our view, a number of factors are conspiring to produce a modest reduction in housing market activity and a moderate slowdown in house price appreciation during the balance of 2005 and in 2006. These factors include the projected rise in the interest rate structure (spurred by the Fed), less usage of “exotic” adjustable-rate mortgage products (thanks to financial regulators and rating agencies), and a reduced presence of investors/speculators in the single-family and condo markets (thanks to the previous factors). Fortunately, these factors will be at play in the midst of a healthy economic expansion that will be generating increases in employment and personal income that, by their nature, support housing demand.
Our forecast continues to show modest fades in home sales and housing starts over the balance of this year, followed by year-over-year reductions of roughly 6% in 2006. In this forecast, house price appreciation slows to a year-over-year pace of about 6% next year, close to the long-run average.
We expect the near-term housing patterns to include some recovery in the market share of rental housing and a relatively stable pattern for multifamily housing starts. We also expect the residential remodeling market to maintain good forward momentum, with the support of housing equity generated through the price gains of recent years. Shipments of manufactured homes are not likely to pick up significantly from recent depressed levels, remaining a minor part of the U.S. housing market.
Housing production, in total, should decline gradually in coming quarters following the remarkable growth surge of recent years. In the process, residential fixed investment should swing from a powerful engine of economic growth to a modest drag on GDP.
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. 24 edition. To subcribe to “Eye on the Economy,” click here
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