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Eye on the Economy: Fed Is Near End of Its Rate-Hike Process
 Above-Trend Growth Is Pushing the Economy Toward Some Limits
The U.S. economy still is on a solid growth path and has been running somewhat above the sustainable trend pace for the past few years ― based on our estimates of trend growth in the labor force and labor productivity.
Growth of real Gross Domestic Product (GDP) will be around 5% in the first quarter of this year, following temporary hurricane-related weakness in the final quarter of 2005, and we expect second-quarter growth to hold in the above-trend range.
An extended period of above-trend GDP growth reduces slack in labor markets and generally results in rising rates of capacity utilization in the industrial sector. Both developments have been evident during the past year.
At some point, tightening resource markets generate inflationary pressures, and GDP growth must fall to (or below) trend if a reasonably balanced economic expansion is to carry forward for some time. Our forecast shows slightly below-trend GDP growth in the second half of this year and in 2007, and that should be viewed as a healthy development.
Strong Employment Growth Continues to Reduce Slack in Labor Markets
Above-trend GDP growth has generated solid growth in employment and systematic reductions in the unemployment rate since the summer of 2003, despite maintenance of healthy gains in labor productivity (output per hour). Earlier in the expansion, tepid GDP growth combined with an early-cycle surge in productivity left us with a job-losing economic “recovery,” but all that has changed (at least nationally).
The employment report for March was another healthy one, showing a 211,000 increase in payroll employment and a downtick in the unemployment rate to 4.7% — the lowest for the expansion to date. That’s certainly good news, but the gradual reduction of slack in the labor market has been putting systematic upward pressure on average hourly earnings, and unit labor costs have been on the rise as growth of labor productivity has slowed from that early-cycle surge.
One of the culprits in this plot is a low and stagnant labor force participation rate (around 66%), a factor that contributes to labor market tightness as the economy expands.
Core Inflation Still Appears to Be Pretty Much Under Control
Dramatic shifts in energy prices have been pushing headline inflation numbers all over the place, but it’s “core” inflation (excluding food and energy prices) that really matters when the future of the economic expansion is at stake. Our central bank is preoccupied with core inflation, and it appears that the Fed has established “tolerance ranges” to guide the management of monetary policy.
The core Producer Price Index (PPI) is down the list in order of importance, since the Fed is not preoccupied with inflation at this level, but it’s hardly irrelevant to the inflation process. The core PPI for finished goods was up by only 1.7% on a year-over-year basis in March, the same as in February and well below rates recorded during most of last year.
Core inflation at earlier stages of production (intermediate and crude goods) is running a good bit higher, but that’s a long distance from the inflation rates the Fed worries about.
The core Consumer Price Index (CPI) is more prominent on the Fed’s radar screen, and it appears that the Fed’s tolerance range for the core CPI is between 1.5% and 2.5% (year-over-year basis). This measure showed a 2.1% gain in March, the same as in January and February and still well within the Fed’s range.
However, the technically superior chain-core CPI (allowing for substitution among goods and services in the market basket) showed a year-over-year gain of 2.0%, up from 1.8% in the previous three months. The upper end of the Fed’s tolerance range for the chain-core CPI presumably is around 2.2%, so we’re getting pretty close on that front.
The Fed Is Near the End of Its Rate-Hike Process
The Federal Reserve has hiked the federal funds rate by 25 basis points at each of the 15 Federal Open Market Committee (FOMC) meetings held since mid-2004, and the funds rate now stands at 4.75%. The Fed’s expressed objective has been to remove the massive monetary policy “accommodation” poured into the economy between mid-2003 and mid-2004 and get policy back to “neutral” before the economy generates serious inflation pressures.
The public statement issued at the conclusion of the last FOMC meeting on March 28 hinted at an additional quarter-point rate hike at the next policy meeting on May 10, and financial markets have been speculating about even more tightening down the line. But the minutes from the March 28 meeting released last week suggested that some FOMC members are not actually preoccupied with inflation dangers, and some expressed concerns that monetary tightening could go too far — particularly in view of well-documented lagged effects of monetary tightening on the economy.
We’ve been assuming just one more Fed tightening move (on May 10), and the FOMC minutes reinforce our judgment on that point.
Long-Term Interest Rates Approach Four-Year Highs
The apparent preoccupation with potential inflation pressures in the March 28 FOMC statement put some upward pressure on longer-term rates, and upward rate adjustments by some foreign central banks added to these pressures as questions were raised about the durability of huge inflows of foreign capital into U.S. fixed-income markets.
As a result, the entire Treasury yield curve has moved upward, and the 10-year Treasury yield is now hanging around 5% — the highest since mid-2002 and right on NAHB’s current forecast for the second quarter of the year.
Looking forward, we expect the yield curve to move up a bit further and retain a slight positive slope, diffusing concerns by anybody inclined to fret about the economic implications of an inverted yield structure.
Interest rates on home mortgages have continued to move upward with Treasury rates. The average rate on the 30-year, fixed-rate conventional mortgage (FRM) climbed to 6.49% in the second week of April, and the going rate on Treasury indexed one-year, adjustable-rate mortgages (ARMs) climbed to 5.61% despite sizeable initial rate discounts by lenders.
NAHB’s forecast shows further modest increases in the mortgage rate structure over the balance of 2006. We’re also likely to see less favorable rates and terms on various “exotic” forms of ARMs — such as interest-only and payment-option structures ― that soon will be subject to supervisory guidance from federal regulators.
Housing Market Indicators Illustrate the ‘Cooling Down’ Process We’ve Been Projecting
NAHB’s single-family Housing Market Index showed another decline in April, falling to the lowest level since a temporary plunge in the wake of the terrorist attacks on 9/11. The HMI now is at 50, the balance point between positive and negative builder perspectives regarding the demand for single-family homes.
The index of applications for mortgages to buy homes (Mortgage Bankers Association series) also continues to illustrate the downshift in demand. In the second week of April, this measure was down by 17% from the cyclical peak at mid-2005 (four-week moving average basis) despite a modest rise since mid-March as committed buyers apparently moved to lock in mortgage rates in a rising rate environment.
Housing starts were quite strong in the January-February period despite an obvious downtrend in housing demand as well as NAHB builder surveys that illustrated builder recognition of that downtrend. But total starts were down by nearly 8% in March and the single-family component retreated by 12%.
Even so, the first-quarter averages for total, single-family and multifamily starts all hit cyclical highs. Positive weather effects appear to be largely responsible for that conundrum — weakening demand but strengthening supply.
A ‘Soft Landing’ for Housing Still Is the Best Bet
Unsold inventories of new homes definitely are elevated at this time. Many builders are reporting an upshift in cancellations of sales contracts signed earlier, and many companies, particularly larger ones, are telling us that investors/speculators are not only cancelling sales contracts but also reselling homes they had closed on earlier. And it’s obvious that home purchases by investors/speculators are well down from this time last year.
In view of these evolving developments, we’re still projecting downward adjustments to home sales and housing starts over the balance of this year and in 2007.
The anticipated degree of decline in starts for 2006 (6%-7%) still qualifies as a “soft landing” for the housing market following unsustainable exuberance in 2005. We expect much of the decline to reflect withdrawal of investors/speculators from housing markets as the change in supply-demand balance takes a toll on price appreciation and price expectations in single-family and condo markets.
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 19 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.
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For more details, visit www.housingeconomics.com.
 Attend the Spring Construction Forecast Conference in April
Plan to attend NAHB's Construction Forecast Conference on April 27 at the National Housing Center in Washington, D.C. The conference brings together the nation's premier housing economists and finance experts for an in-depth examination of the economic outlook for the housing industry.
For more information, visit www.nahb.org/cfc.
Seiders Predicts 'Soft Landing' on the NAHB Economics Blog
NAHB Chief Economist David Seiders says a "soft landing for housing is still in the cards" on NAHB's economics blog, “Seiders on Housing” — an informal Internet-based forum dealing with economic issues, housing trends, survey research and other topics affecting the housing sector of the economy.
Log onto the blog at http://nahbblog.blogs.com and get direct access to Seiders' expert opinions, projections and responses. Then let Seiders know what you think by giving your perspective.
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