The Economy Is Generating Solid Growth in Output and Employment With Low Inflation
Despite some quarter-to-quarter ebbing and flowing, the U.S. economy has been on a solid growth path for some time and the near-term outlook remains favorable.

Indeed, average growth of economic output (real Gross Domestic Product) has been modestly “above trend” for the past few years, and this performance has generated solid growth in employment and reductions in the unemployment rate despite maintenance of healthy gains in labor productivity (output per hour).

The economic expansion has yet to generate serious inflation problems, despite tightening labor markets and historically high energy costs. In fact, key measures of core inflation (excluding prices of food and energy) were well behaved through February, remaining below the upper end of the Fed’s apparent “tolerance zone.”  Even so, we’ve probably reached the point where further above-trend GDP growth and associated declines in the unemployment rate would begin to put upward pressure on core inflation and threaten the longevity of the economic expansion.
 

 
The Fed Hikes Rates Again and Hints About Further Tightening
As expected, the Federal Reserve enacted another quarter-point increase in short-term interest rates at the March 28 meeting of the Federal Open Market Committee (FOMC).  This adjustment raised the federal funds rate target to 4.75% and took the bank prime rate to 7.75% — 3.75 percentage points above the cyclical lows that prevailed from mid-2003 to mid-2004.

This was the first FOMC meeting chaired by Ben Bernanke, and the FOMC’s public statement bore a lot of similarities to the final statement in the Greenspan era (January 31). In particular, the statement revealed preoccupation with inflation issues, stressing that “possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.”  The statement went on to say that “some further policy firming may be needed,” the same hint issued at the conclusion of the previous meeting.

It’s pretty clear that the Fed wants to slow down economic growth and keep the unemployment rate from falling much (if any) further. Thus, it’s highly likely that the FOMC will enact another quarter-point rate hike at the next meeting on May 10 — a move that’s incorporated in NAHB’s forecast. This adjustment most likely will edge monetary policy slightly beyond the “neutral” position that the Fed has been pursuing since mid-2004, making policy slightly restrictive for the first time in this economic expansion. [return to top]
 

 
The Entire Interest Rate Structure Is Shifting Upward
The tone of the March 28 FOMC statement seemed to catch the financial markets a bit by surprise, and interest rates gravitated upward across the maturity spectrum in the wake of the meeting. Upward rate adjustments by some foreign central banks (particularly the European Central Bank) also appeared to put upward pressure on our longer-term rates, as questions were raised about the durability of huge inflows of foreign capital into U.S. fixed-income markets. In any case, the entire Treasury yield curve has moved upward, and the 10-year Treasury yield now stands at about 4.85%, the highest since mid-2002 and quite close to NAHB’s forecast for the second quarter of the year (4.9%).

Interest rates on home mortgages have moved upward with Treasury rates. The average rate on the 30-year, fixed-rate conventional mortgage (FRM) climbed to 6.35% in the final week of March and the 15-year rate moved up to 6.0%. The going rate on Treasury indexed one-year, adjustable-rate mortgages (ARMs) climbed to 5.51% despite initial rate discounts by lenders in excess of two percentage points. NAHB’s forecast shows modest further increases in the mortgage rate structure over the balance of 2006. [return to top]
 

 
Housing Demand Continues to Weaken as Affordability Moves Downward
The demand for single-family homes and condo units peaked during the second half of last year and has moved downward since then. This change of direction has occurred as record-high house prices and rising mortgage rates have taken a heavy toll on affordability.  Eroding expectations of future house price appreciation may also be contributing to the erosion of demand, particularly among investors/speculators.

While the change in market direction (from up to down) is convincing, it’s fair to say that housing indicators have been a mixed bag in recent times. NAHB's single-family Housing Market Index has come down substantially and systematically from the cyclical peak in June 2005; indeed, the March reading was 24% below that peak. Sales of new homes have rattled down irregularly since July of last year and stood 21% below that peak in February. Sales of existing single-family homes and condo units (based on closings) hit cyclical peaks last June and were down by 5% (combined) by February — despite a 5% rebound in February that flew in the face of a systematic trailing down of “pending” sales (based on contracts signed) through that month. Finally, the index of applications for mortgages to buy homes (Mortgage Bankers Association series) fell by 18% between its mid-2004 high and the final week of March (4-week moving average basis), despite increases in the second half of that month.

Housing demand clearly is down from the highs of last year, but recent momentum is not as clear. That’s partly due to seasonal adjustment problems this time of year. Furthermore, demand may be enjoying temporary support from acceleration of mortgage applications and home purchases at a time when expectations of future mortgage rates are being marked up.  Everything considered, it’s reasonable to conclude that, fundamentally, demand still is eroding and will move down somewhat further as 2006 rolls along. [return to top]
 

 
New-Home Production Is Still Growing and Unsold Inventories Are On the Rise
Total housing starts averaged 2.21 million units (annual rate) for the January-February period, higher than any quarterly average for the entire expansion period, and the same can be said for the single-family component which averaged 1.82 million for the first two months of this year.  The strong forward momentum of housing starts kept residential construction put-in-place on a strong upward trend through February, particularly for new single-family units. Indeed, single-family construction in February was 14% above a year earlier (nominal terms) and showed increases during every month of that period.

Maintenance of strong production in the face of eroding final demand for homes has resulted in record levels of unsold new-home inventories and a large increase in the months’ supply — from 4.1 last July to 6.3 in February. Furthermore, these inventories don’t include homes handed back to builders when sales contracts are cancelled! [return to top]
 

 
A “Soft Landing” for Housing Still Is the Best Bet
The supply-demand balance in housing markets obviously has changed dramatically since mid-2005, and further increases in mortgage interest rates are bound to take an additional toll on housing demand.  We’re also looking for a modest slowdown in job and income growth later this year and in 2007 as the Fed guides the economy onto a more sustainable growth path.

The recent inventory buildup poses a real threat to the new-home market, but we believe that a lot of that buildup represents temporary weather-related factors.  Thus, we’re still projecting a “soft landing” for housing, with housing starts and home sales off 7 to 8% for 2006 as a whole.  The condo market figures to weaken the most while the rental component of the multifamily sector may well post an increase following years of erosion. [return to top]