The mid-year economic ‘soft patch’ now looks like a more serious matter …
A number of economic indicators for June had identified a “soft patch” in the economic expansion, a lull that appeared both minor and temporary to a wide range of observers --including Fed Chairman Alan Greenspan. However, data received during the past few weeks suggest that the mid-year slowdown has turned out to be more serious than expected by private forecasters, the Administration and the Federal Reserve.

The first big shoe dropped on June 30 when the Commerce Department released the “advance” report on Gross Domestic Product (GDP) for the second quarter. This report showed annualized GDP growth of only 3.0%, well below market expectations, and revealed a major slowdown in growth of consumer spending — to only 1.0%. Furthermore, data released a few days later showed that the real value of consumer spending weakened badly during the second quarter, and actually contracted by 0.9% in June. That pattern certainly does not bode well for economic momentum moving into the third quarter of the year.

The other big shoe dropped on Aug. 6 when the Labor Department released the employment report for July. Contrary to consensus expectations, payroll employment was revised down by 61,000 for the May-June period, and the July increase was a paltry 32,000 (market consensus was around 240,000).

It’s true that the household survey showed a slight reduction in the unemployment rate (from 5.6% to 5.5%) and strong growth in household employment (629,000). However, notorious volatility in the household employment estimates kept this number out of the headlines while the payroll employment numbers (based on a survey of business establishments) rightfully captured most of the attention.

The falling shoes are terrible news for the Bush Administration and major complications for the Greenspan Fed. Is Greenspan’s “soft patch” just a bit softer than expected or did the economy hit some dangerous quicksand in the middle months of 2004? NAHB’s forecast still shows GDP growth around 4% for the second half of the year, but the range of risk around that forecast certainly has widened.

Revisions of economic history brighten the housing star but pose complications for future growth …
On July 30, the Commerce Department released the annual 3-year revision of the National Income and Product Accounts in conjunction with release of the “advance” estimate of GDP for the second quarter of this year. The net impact of the revisions on the level of real GDP by the first quarter of this year was negligible even though the 2001 economic downswing now is shallower and the first year of recovery is weaker than previously estimated.

Indeed, both the existence and the timing of the 2001 “recession” have been called into question by the GDP revisions, and it remains to be seen how the political parties will try to spin that revelation.

The three-year GDP revision had little impact on the housing production component (residential fixed investment or RFI) in 2001 or 2002, but the strength of RFI was revised up substantially in 2003 and the first quarter of 2004 — primarily the component for new single-family homes. Indeed, RFI growth averaged 10.7% over this period, followed by 15.4% growth in the “advance” estimate for the second quarter. So, the housing star shines even more brightly than before in the economic skies.

The GDP revisions revealed a few structural changes that may complicate the ability of the economy to shake off the mid-2004 slowdown and shift back to a stronger growth path. These include downward revision to business investment in capital equipment and software as well as to corporate profits — with negative implications for the capital stock as well as for the equity markets.

There also was a downward revision to the personal saving rate, with negative implications for consumer spending going ahead. Finally, GDP inflation was revised up a bit and there were a few inflationary implications for the future as well, including the likelihood of stronger upward pressures on unit labor costs. [return to top]

Soaring energy prices contribute to the mid-year economic slowdown …
Sharply rising oil prices have acted like a tax on the U.S. economy, cutting into the real value of consumer spending while raising business costs and depressing the stock market (the benefits to U.S. oil companies are only a small offset). Indeed, crude oil prices recently hit record highs, and the outlook is quite murky.

In fundamental terms, upward pressures on oil and gasoline prices reflect strengthening global demand, scarce global productive capacity for crude oil, lean stockpiles and limited domestic refining capacity. But various global uncertainties are boosting prices above levels implied by fundamentals alone.

These uncertainties range across political problems in Venezuela and Nigeria, financial problems threatening the huge Yukos company in Russia and a host of problems and uncertainties in the Middle East — including not only the frequent acts of sabotage in Iraq but also worries over terrorism in Saudi Arabia and the possibility of a confrontation with Iran over its nuclear program.

Oil market experts say that crude oil prices should recede from recent highs of $45/barrel to about $35/barrel, implying a $10 premium associated with the set of global uncertainties. But nobody knows when the market fundamentals will take over.

In this environment, we’re fortunate to have a powerful and flexible central bank with the ability to help offset adverse impacts of global oil market volatility on the domestic economy. [return to top]

The Fed goes ahead with a quarter-point rate hike and talks about balanced risks to the economy …
The Fed went ahead with a widely anticipated quarter-point increase in its federal funds rate target (to 1.5%) at the Aug. 10 Federal Open Market Committee (FOMC) meeting, despite the obvious mid-year slowdown in economic growth and job formation. The FOMC statement noted that “output growth has moderated and the pace of improvement in labor markets has slowed” in recent months, and the FOMC pinned a lot of the blame on the rise in energy prices. The FOMC went on to say that the economy “appears poised to resume a stronger pace of expansion going forward.”

The FOMC statement once again characterized the upside and downside risks to the attainment of both sustainable economic growth and price stability as “roughly equal” for the next few quarters. The statement also continued to say that “policy accommodation can be removed at a pace that is likely to be measured,” wording that was used at the two previous FOMC meetings. It’s noteworthy that the Aug. 10 rate increase simply brought the real (inflation adjusted) funds rate back up to zero, and that’s still quite accommodative.

In a nutshell, the Fed recognized the mid-year slowdown in the economy but argued that the problem is temporary. The tone and content of the statement strongly suggest that the funds rate will be raised again at the Sept. 21 FOMC meeting (the last one before the November elections) as the Fed marches toward monetary neutrality.

NAHB’s forecast still shows the federal funds rate at 2% by the end of this year and 4% at the end of 2005. [return to top]

Long-term interest rates shift down again, providing unexpected support to housing …
Accumulating evidence of the June-July economic slowdown provoked a substantial downshift in long-term interest rates from the recent highs in late July, and the FOMC decision/statement on Aug. 10 provoked only a minor backup despite the FOMC’s expression of confidence in the underlying strength of the economic expansion. Indeed, 10-year Treasury yields are down about 30 basis points since July 29, and fixed-rate home mortgage yields are once again comfortably below 6%.

The current yield structure obviously is quite supportive of the housing market. Home sales and housing starts should be quite good in the third quarter, although it’s going to be tough to match or exceed the robust second-quarter performance.

We still expect the housing numbers to fade later this year and in 2005 as the Fed continues to tighten and the entire yield structure gravitates upward. However, 2004 is bound to be a record year for single-family housing and the falloff next year should be of minor proportions. [return to top]

New White House budget projections bode well for the interest rate structure and for housing …
The White House Office of Management and Budget (OMB) released its annual mid-session review of the federal budget on July 30. The new projections show smaller deficits for the 2004-2009 period than had been projected back in February, particularly for the 2004-2005 time frame. The fiscal 2004 deficit now is estimated at $445 billion, still a record high but $76 billion below the February projection.

The new budget projections continue to reflect the Administration’s commitment to cut the deficit by half in five years, and the projected pattern lowers the deficit/GDP ratio from 3.8% in 2004 to 1.5% in 2009. That’s quite a positive development for the interest rate outlook — and for the housing outlook — as long as the projections are realized.

The economic projections involved in the Administration’s new budget projections are reasonable enough. Furthermore, the projected government revenues simply assume maintenance of the current tax structure, and projections of mandatory spending (Social Security, Medicare, etc.) are based on current program structure.

But the degree of fiscal restraint assumed in the projections of discretionary federal spending may very well be too optimistic, particularly since the various Congressional “rules” and “caps” expired several years ago. The actual outcome will depend critically on spending decisions made by Congress and the White House during the years ahead. [return to top]