Eye on the Economy: 'Soft Landing' Will Have Rough Spots
The Commerce Department’s preliminary estimate of real gross domestic product (GDP) for the first quarter of this year showed robust 5.3% growth, up from the “advance” estimate of 4.8% and well above sustainable trend growth.
Consumer spending was the major driver of first-quarter growth, and solid contributions also were provided by nonresidential fixed investment, exports and spending by the federal government. Residential fixed investment made a modest contribution to GDP growth.
GDP growth is definitely slowing toward a more sustainable pace in the second quarter. NAHB’s forecast currently shows 3.0% growth, reflecting a major slowdown in consumer spending along with less exuberant business investment and a swing of residential fixed investment into the negative zone following an extended period of highly impressive growth.
The Growth Slowdown Will Extend the Economic Expansion
We’re still projecting a pattern of below-trend GDP growth — a bit above 3% ― in the second half of this year and in 2007, and we continue to view this pattern as a mid-cycle correction that will extend the economic expansion for at least several more years.
Nearly three years of average above-trend GDP growth have generated solid growth in employment and systematically reduced the degree of slack in U.S. labor markets — demonstrated by a falling unemployment rate from the cyclical high in mid-2003 to an expansion low of 4.7% in April.
The evolving (and projected) slowdown in GDP growth will prevent the unemployment rate from falling much (if any) further in the near term, and NAHB’s forecast shows an upward drift during the second half of this year and in 2007. Indeed, loosening of labor market conditions is essential to maintenance of an economic expansion with low inflation in coming years.
Core Inflation Is a Growing Threat to the Economic Expansion
The extended period of above-trend GDP growth and the associated shrinkage of slack in U.S. labor markets have generated growing concern on the inflation front. The Fed is quite worried about upward pressures on “core” inflation (excluding prices of food and energy) from tightening labor markets as well as from soaring energy prices that inevitably have been making their way into the core through business cost structures.
Core inflation readings for the first quarter of 2006 were reasonably well contained, at least on a year-over-year basis, although various measures definitely firmed up on a quarter-to-quarter basis. Furthermore, available data for April show further acceleration.
The core consumer price index (CPI) definitely is on an upward path, showing annualized increases of 3.6% in both March and April, and the April reading was up by 2.3% on a year-over-year basis — not far below our estimate of the upper bound of the Fed’s tolerance zone for this inflation measure (2.5%).
The Fed’s favorite inflation gauge, the core price index for personal consumption expenditures (PCE) rose at an annual rate of 3.0% in April and was up by 2.1% on a year-over-year basis — slightly above our estimate of the upper end of the Fed’s tolerance zone for this measure (2.0%).
The evolving slowdown in economic growth, and the associated loosening of the labor market, should relieve upward pressure on core inflation before long. We expect the key PCE price index to drift back within the Fed’s tolerance zone by late this year.
The Fed Is Being Pulled by Opposing Forces
The Fed raised the federal funds rate target to 5% at the last meeting of the Federal Open Market Committee (FOMC) on May 10, taking the “real” (inflation-adjusted) funds rate to about 3% — slightly restrictive by historical standards.
With respect to future policy moves, the FOMC statement said that “some further policy firming may yet be needed to address inflation risks,” but the statement also emphasized that future policy moves will be highly data-dependent.
Our forecast continues to assume that the Fed will maintain the current policy stance for some time. However, evidence of slowing economic growth and limits on core inflation will have to be convincing to hold off yet another quarter-point rate hike at the next FOMC meeting on June 29.
The April readings on core CPI and PCE inflation tilted the odds toward at least one more rate hike this year, while the obvious slowdown in GDP growth in the second quarter argues for policy stability. Only time will tell.
Long-Term Rates May Now Be Range Bound
Long-term interest rates have been hanging around four-year highs for several weeks, as upward pressures generated by surprisingly high core inflation readings have been roughly neutralized by some tepid economic indicators (including a downshift in consumer spending in April) and an associated flight of capital from the stock market to the bond market. The 10-year Treasury yield has been close to 5.1% for more than a month, and the long-term home mortgage rate has been holding around 6.6%.
Expectations of future monetary policy adjustments, as well as inflation expectations, are built into the current yield structure, and the future course of long rates will depend on how well actual developments square with those expectations.
NAHB’s forecast allows for a slight further rise in 10-year Treasury yields this year (to 5.2%), and we’re showing a similar rise in the fixed-rate home mortgage yield (to 6.7%). This forecast is contingent on a slowdown in economic growth, a slowdown in employment growth, an uptick in the unemployment rate, containment of core inflation and maintenance of a 5% funds rate.
Indeed, if things fall perfectly into place, long-term rates may hardly move at all.
The ‘Moderate’ and ‘Orderly’ Housing Slowdown Appears to Be on Track
NAHB’s national housing forecast shows a moderate and orderly cooling-down process that began late last year and extends into the middle of 2007. In this regard, the forecast currently shows a 14% decline in total housing starts from the third quarter of 2005 to the third quarter of 2007.
It’s noteworthy that both the former Federal Reserve chairman, Alan Greenspan, and the current chairman, Ben Bernanke, basically concurred with this type of pattern in public statements issued in May, using words like “moderate,” “orderly” and “cooling” when referring to the evolving path of home sales, housing production and house price appreciation.
The national “soft landing” scenario views the evolving housing slowdown as a downward adjustment from unsustainable rates of activity in 2005 rather than as a classic cyclical contraction.
In this regard, the current slowdown looks a lot like the 1994-1995 episode rather than the deep housing recessions of the early 1980s or the early 1990s. With respect to causes, the current slowdown largely reflects serious affordability problems caused by systematic increases in the interest rate structure on top of years of rapid home price appreciation.
The projected slowdown also reflects a pullback by investor/speculators that spurred the market to new heights last year. Investors/speculators have not only been cutting back on new purchases but also have been cancelling sales contracts and reselling single-family homes and condo units closed on earlier.
The ‘Soft Landing’ Will Have Some Rough Spots
NAHB’s forecast of a “soft landing” for the U.S. housing market in 2006 and 2007 recognizes that the landing will feel pretty rough in some areas of the country. The rough spots will include places that soared into the stratosphere in 2005 as well as places that hardly got off the ground following the national economic recession of 2001.
The national housing boom that topped out late last year was concentrated in markets in the West, the Northeast corridor and Florida. Many of the high-flying metro markets now are heading back toward earth, and a pullback by investors/speculators is hastening the process.
Rough landings for single-family and/or condo markets are possible in places like Las Vegas, Phoenix, Orlando, Miami and Washington, D.C. Furthermore, bumpy conditions are developing in other Florida markets, in much of California and in other parts of the Northeast corridor.
The national economic expansion has left some parts of the country far behind, and housing markets in those areas face downside pressures that are entirely different from the issues faced by the high flyers.
The “earthbound” housing markets are in structurally weak economies concentrated in the Great Lakes region of the Midwest, in New England and in the storm-ravaged Louisiana-Mississippi area. The structurally weak economic areas have little hope for rebound in 2006-2007 as the national economy slows toward trend. Furthermore, rising interest rates now are weighing on these economies, and the Federal Reserve has no way to regionalize the effects of monetary policy.
While builders in the earthbound markets don’t have to deal with violent swings in home buying/selling by investors/speculators, weak fundamentals loom large. This reality has already prompted geographic diversification by a number of larger companies headquartered in places like the industrial Midwest.
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 May 31 edition. To subcribe to “Eye on the Economy,” click here.
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