Eye on the Economy
By David F. Seiders, NAHB Chief Economist
The U.S. Economy Already Is Leaving Negative Hurricane Effects in Its Wake
Hurricane Katrina hit the Gulf Coast on Aug. 29, and Rita and Wilma were not far behind. The immediate impacts caused an outright reduction in U.S. economic output in September, but strong pre-hurricane momentum carried economic growth forward for the third quarter as a whole.
Indeed, the Commerce Department has just revised growth of real gross domestic product (GDP) upward to an annual rate of 4.3% for the third quarter ― the fastest pace since early 2004. The housing production component of GDP grew at a robust 8.4% pace and contributed half a percentage point to the overall GDP growth rate. That’s a lot.
Incoming data reinforce the pattern of solid underlying momentum in growth of real economic output into the fourth quarter, despite some lingering negatives from this year’s record-breaking hurricane season. We’re projecting 3.4% growth of real GDP in the fourth quarter, a very nice performance, and we expect even stronger growth early next year as the hurricane effects swing from negative to positive.
Retreating Energy Prices Lower a Key Economic Stumbling Block
Energy prices were historically high prior to Katrina, and the onslaught of the hurricanes drove these prices up sharply to new record highs. The price surges were fueled not only by immediate disruptions to supply, particularly for gasoline, but also by severe assessments of the degree of damage to energy production and transmission infrastructure along the Gulf Coast.
We now know that imports of crude oil and refined petroleum products quickly helped to fill in for lost domestic production, and it’s become clear that the degree and duration of damage to our energy infrastructure were not as severe as initially believed. As a result, prices of crude oil and gasoline have fallen substantially from their post-Katrina peaks and now actually stand below pre-hurricane levels.
Although natural gas prices promise to remain elevated for some time, the dramatic turnaround in other components of the energy markets has brightened the picture for both near-term real economic growth and core inflation.
The National Labor Market Is Fundamentally Healthy Despite Problems on the Gulf Coast
The labor market started to show systematic cyclical improvement in the fall of 2003, and the strengthening pattern continued until Hurricane Katrina hit the Gulf Coast at the end of August. National payroll employment fell slightly in September and showed only a slight increase in October (preliminary data) as the hurricanes took their toll on jobs in the Gulf area.
Despite the hurricane-related setbacks, the national labor market still is fundamentally healthy, and the forward momentum of real economic output (GDP) is sure to lift the payroll employment numbers in the immediate future (we expect a solid increase in November). Indeed, trends in seasonally adjusted claims for unemployment insurance, excluding identifiable hurricane effects, suggest a continued strong trend in employment growth. That’s very good news, of course, but rising labor costs are likely to create complications on the inflation front down the line.
Core Inflation Remains Under Control Despite Spikes in Energy Prices
The hurricane-related surge in energy prices drove both the producer price index (PPI) and the consumer price index (CPI) out of sight in September, while the core components of both measures (excluding prices of food and energy) remained in the historically low ranges prevailing since early this year.
A slowdown in energy price inflation at the wholesale level brought down overall PPI inflation to some degree in October, and an outright decline in energy prices at the retail level reduced overall CPI inflation considerably. The news on core inflation was even better, as the core PPI for finished goods slowed to a 1.9% year-over-year pace and the core CPI posted a modest 2.1% increase. The technically superior chain-core CPI (allowing for substitution among goods and services in the market basket) showed a year-over-year rise of only 1.7% in October, the slowest pace in a year.
These performances hardly mean that core inflation is a non-issue, and the Fed has been stressing inevitable pass-through of historically high energy prices into the core down the line. The stunning reversal of the hurricane-induced spike in energy prices has diffused that issue to some degree, although some increase in core inflation still seems inevitable in both 2006 and 2007 as energy prices remain at high levels and labor markets tighten further.
The Fed Is Approaching the End of Its Rate-Hike Cycle
The Federal Reserve raised the federal funds rate to 4.0% at the Nov. 1 meeting of the Federal Open Market Committee, and the FOMC issued a statement saying that monetary policy remained accommodative (even after the rate hike) and that remaining policy accommodation can be removed at a “measured pace.” The FOMC statement also stressed strong underlying momentum in real economic activity as well as heightened risks to core inflation due to record high energy prices.
These messages pointed toward an extended series of quarter-point rate hikes that could extend well into 2006, and some private sector forecasts showed the funds rate as high as 6% by the end of next year. However, the combination of good news on core consumer price inflation for October and large declines in energy prices from post-hurricane highs softened the outlook for Fed policy, and the minutes from the Nov. 1 FOMC meeting showed less inflation concern than the markets had feared.
We still expect the Fed to hike the federal funds rate to 4.25% at the Dec. 13 FOMC meeting, and we still believe that the funds rate will top out at 4.50% at the Jan. 31 meeting (Fed Chairman Alan Greenspan’s last FOMC meeting). Ben Bernanke, the President’s nominee to replace Greenspan, may accent the Fed’s inflation-fighting resolve with a quarter-point rate hike at his first FOMC meeting (March 28), but we’ll just have to wait and see about that.
FOMC Minutes and Bernanke Testimony Help Contain Long-Term Rates
The minutes from the Nov. 1 FOMC meeting (released on Nov. 23) showed maintenance of strong anti-inflation resolve at our central bank but also revealed an emergence of concern about the risks of “going too far with the tightening process.” The minutes also suggested that references to “accommodative” monetary policy and messages about future policy moves (the “measured pace” language) are likely to disappear from FOMC statements before long. In this regard, the minutes noted that policy changes “would need to be increasingly sensitive to incoming economic data” rather than being dominated by an inexorable upward drift toward an elusive definition of monetary neutrality.
Mid-November testimony before the Senate Banking Committee by Bernanke also appeared to calm financial markets. Bernanke made it perfectly clear that he is not dovish on inflation and that he will be “strictly independent of all political influences” as Fed chairman. With respect to explicit inflation targeting by the Fed — a prominent Bernanke theme in his earlier academic circles ― the nominee stressed that “judgment and flexibility” would remain important in the policy-making process and that an inflation target would “in no way reduce the importance of maximum employment as a policy goal.”
The soothing effects of the FOMC minutes and the Bernanke testimony halted the upshift in long-term rates that had begun around mid-September, and long rates have changed little, on balance, since mid-November. We’re still expecting long-term rates to move up by about half a percentage point during the next year, taking the fixed-rate home mortgage to about 6.75% in late 2006, but the impacts of our projected upshift in the interest rate structure on housing and the economy should not be severe.
The Housing Market Apparently Has Begun to ‘Cool’ Following an Impressive Run
Although there are some mixed signals, the majority of housing market indicators now suggests a recent topping-out of home sales and housing production. Thus the long-awaited “cooling” process apparently is underway after an unprecedented multi-year housing surge.
Housing starts and permit issuance moved down convincingly in October, showing reductions for both single-family and multifamily units, and the declines were broad-based by region. The backlog of unused permits also moved down, pretty much across-the-board, tempering the outlook for housing starts in November.
Measures of home sales were mixed for October. Sales of existing single-family homes (based on closings) were down moderately for the month, and all regions showed some erosion. On the other hand, new-home sales (based on contract signed or deposits taken) posted a surprising 13% increase in October as the Northeast and West regions showed 43% and 47% month-to-month increases, respectively. But immense confidence intervals surrounding the Commerce Department’s estimates of new-home sales, particularly for the Northeast and West regions, challenge the reliability of the preliminary calculations.
At this point, we’re highly skeptical of the new-home sales report for October and believe that subsequent revisions as well as estimates for future months will be more consistent with the cooling process we’re convinced is underway.
Recent Surveys and Affordability Measures Point Downward
Our confidence in the cooling process is reinforced by monthly surveys of single-family homebuilders (conducted by NAHB) and weekly surveys of home mortgage lenders (conducted by the Mortgage Bankers Associations). Our single-family housing market index (HMI) fell sharply in early November and is well below the cyclical high in June. Indeed, all the components of the HMI (current sales, buyer traffic and sales expectations) are well off recent highs, and all regions are down significantly as well.
From the lenders’ perspective, the MBA’s index of applications for mortgages to buy homes was essentially flat during the July-September period and gravitated downward during October and most of November (four-week moving average basis).
Available data obviously do not build an ironclad case of systematic cooling in the single-family housing market. But deteriorating measures of affordability, including NAHB’s Housing Opportunity Index, are being weighed down by both extraordinarily high house prices and rising mortgage interest rates, and these factors support the case.
Strong Foundations and Post-Hurricane Rebuilding Will Limit Downward Housing Adjustments
While home sales and housing production are bound to move off recent highs, the downward adjustments are likely to be moderate and orderly and will not constitute a classic cyclical contraction. In other words, we’re expecting an adjustment toward “sustainability” after about a year of above-trend sales and production in single-family and condo markets. This process also should involve a slowdown in price appreciation to a more sustainable long-term pace (around 5% nationally).
We’re now updating and extending NAHB’s long-term housing forecasts. This process involves estimation of fundamental demand drivers (household formations, replacement needs and vacancies — including second homes) as well as the composition of supply (single family, multifamily and manufactured home units).
Our forecasts for total new housing units average about 2.1 million units per year for the 2006-2014 period, higher than the average for the first half of this decade (because of relatively high numbers in the out years), and conventionally-built housing units average about 1.9 million units per year. Thus the foundations for housing markets should be quite strong in the years ahead.
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 Nov. 30 edition. To subcribe to “Eye on the Economy,” click here
Want to Know Your State and Metro Forecasts for 2006?
Anticipate the trends, make better decisions and improve your bottom line. "HousingEconomics.com," the online publication from NAHB Economics Group, is your single source for market analysis, forecasts, housing statistics and more. In-depth analysis and detailed Excel tables and overviews are available for all the state and metro forecasts.
“HousingEconomics.com” combines unique scientific research with practical applications providing insights that are original and useful. This interactive Web site at the executive level provides critical data and information quickly, easily and frequently and includes the following features:
- Home Builders Forecast ― state, metro, non-residential, remodeling, etc.
- Exclusive access to NAHB’s staff of economists
- The Seiders' Report
- Housing Market Statistics — 29 tables including housing starts, home prices, building permits, home sales, value of new construction, etc.
- Housing Activity
- In-Depth Analysis
For more details, visit www.housingeconomics.com.