Eye on the Economy: Fed May Put Future Rate Hikes on Hold
GDP growth definitely slowed down in the second quarter, and we’re now estimating a below-trend 2.7% pace. Furthermore, we expect growth to hang around 3% during the second half of this year and in 2007, a modestly below-trend pace that will restore a bit of slack to resource markets, particularly the labor market. We’re viewing the 2006-2007 slowdown as a healthy mid-cycle correction that should lead to more years of sustainable growth without recession.
Housing is serving as a major swing factor in the evolving economic growth saga. Residential fixed investment (RFI) was a major engine of economic growth during the 2002-2005 period. However, RFI made relatively small contributions to GDP growth in both the final quarter of 2005 and the first quarter of 2006, and RFI growth definitely swung into the negative zone in the second quarter of this year.
We expect RFI to continue to erode through early 2007, but much of the negative impact on GDP should be offset by strong growth in investment outlays by businesses as well as by improving net exports.
Employment Growth Is Slowing Toward Trend
Three years of average above-trend GDP growth 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 4.6% in both May and June. The evolving (and projected) slowdown in GDP growth should prevent the unemployment rate from falling further, and NAHB’s forecast shows an upward drift during the second half of this year and in 2007.
The payroll employment survey for June showed a net gain of only 121,000 jobs — there was a modest decline in construction employment — and the average monthly gain for the second quarter came to only 108,000. That’s an annualized gain of roughly 1%, a bit below sustainable trend growth, and our forecast shows payroll employment growth in that range for the next six quarters.
Growth of average hourly earnings accelerated in June, despite the slowdown in payroll employment growth, adding to concerns about gathering upward pressures on prices of goods and services produced in the U.S. economy. Indeed, average hourly earnings for June were up by 3.9% on a year-over-year basis, and the three-month annualized increase came to 4.7% — one of the largest increases in the past decade.
Inflation Continues to Firm Up, Aggravating Our Central Bank
The extended period of above-trend economic growth, along with associated shrinkage of slack in U.S. labor markets, has generated growing concern on the inflation front. The Fed has been increasingly 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 and May showed further acceleration. The core Consumer Price Index definitely is on an upward path, showing year-over-year increases of 2.3% and 2.4% in April and May, respectively — 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), has also been elevated in recent months. The year-over-year rise in May was 2.1%, the same as in April, but the annualized gains over the past one, three and six months were well above our estimate of the upper bound of the Fed’s tolerance range for this measure (2.0%). For a central bank preoccupied with containment of inflation pressures, the acceleration demonstrated by the core PCE price index has been quite troublesome.
The Fed Hikes Rates Again, But May Now Go on Hold
The Federal Reserve implemented another quarter-point hike in short-term interest rates at the conclusion of the June 29 meeting of the Federal Open Market Committee (FOMC), raising the federal funds rate target to 5.25% and taking the bank prime rate to 8.25% — the highest levels since early 2001. The quarter-point rate hike actually sparked a sigh of relief in financial markets since the recent increases in core consumer price inflation and a series of “hawkish” statements from Fed spokespersons had raised fears of a half-point increase from the Fed on June 29.
The FOMC statement, as expected, stressed that future policy decisions will be heavily data-dependent, and the core inflation readings promise to remain troublesome in coming months — if only because of inevitable upward pressures on market rents that drive the “owners’ equivalent rent” components of the core inflation measures.
However, the FOMC statement appeared to signal an even-handed assessment of the risks to both sustainable economic growth and price stability, and it’s possible that the Fed is willing to discount the perverse inflationary pressures stemming from the imputed owners’ equivalent rent component.
NAHB’s forecast assumes that the Fed will not raise short-term rates again this year and that the Fed will be compelled to drop rates a bit by mid-2007 as the unemployment rate gravitates upward and core inflation stabilizes. Long-term interest rates should firm up a bit further in this environment, taking the fixed-rate home mortgage to 6.8% by late this year (quarterly average basis), but long rates should recede later next year if the Fed eases off a bit.
Housing Data Are Mixed, But Generally Point Downward
NAHB’s surveys of builders showed deepening problems in the single-family market through June, as our Housing Market Index fell to the lowest level since April 1995. Builders also reported rising cancellations and inventories as well as resales by investors/speculators of homes closed on earlier.
Furthermore, ongoing erosion in single-family and condo markets is shown by sales/price data for the existing-home market through May (based on closings). We’re also seeing a distinct downslide in issuance of single-family building permits (data through May), and recent reports from public home builders have shown substantial declines in new orders, rising cancellations and rising inventories of units for sale.
Conflicting (positive) signals are coming from a number of government and private sources. Data reported by the Commerce Department for May showed increases for both single-family housing starts and sales of new homes, and the National Association of Realtors® series on “pending” sales of existing homes (based on contracts signed) perked up a bit in May. Furthermore, a weekly series on applications for mortgages to buy homes (from the Mortgage Bankers Association) moved up a bit at the end of June (four-week moving average basis).
Despite the conflicting signals, it seems fair to say that single-family and condo markets still are cooling down in fundamental ways and that the housing slowdown still has some distance to run.
The Housing Sector Will Exert a Drag on Economic Growth in 2006 and 2007
NAHB’s forecast currently shows a 7.4% decline in total housing starts for 2006 as a whole, followed by some further erosion in 2007. We anticipate relatively large slippage in the single-family market while the multifamily market experiences slippage in condos, but a firming in rental market conditions.
The manufactured-home market is already back to earth following a temporary surge in shipments late last year (largely to FEMA for hurricane relief efforts), and we expect shipments to edge down further over the forecast horizon.
The residential remodeling market still is performing well, and we’re projecting modest real growth over the balance of 2006 and in 2007.
Everything included, the housing production component of GDP (residential fixed investment) swung from a positive growth engine to a drag on growth in the second quarter of this year, and we expect that pattern to persist through much of 2007.
The projected decline, on a percentage basis, is somewhat larger than in 1994-1995 or 2000-2001, but not nearly as deep as the reversals connected to the recessions of the early 1980s or early 1990s.
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 July 12 edition. To subcribe to “Eye on the Economy,” click here.
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