Eye on the Economy - 10/06/2004 (Plain Text Version)

By David F. Seiders, NAHB Chief Economist

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Revisions to recent economic history bode well for the near-term outlook…

On Sept. 29, the Commerce Department raised its estimate of second-quarter growth in real GDP to 3.3%, up from the preliminary reading of 2.8%. Thus, the second quarter was essentially on the economy’s long-term potential growth path, softening the widely held view of a mid-2004 “soft patch” in economic activity.

The upward revision to second-quarter GDP reflected improvements to business inventory investment, the trade balance and residential construction. Indeed, residential fixed investment grew at an annual rate of 16.5% and accounted for more than one-fourth of total GDP growth. That’s quite a growth contribution from a component that accounts for only about 5% of the level of GDP.

Available data suggest that GDP growth picked up to about 4% in the third quarter, largely reflecting ongoing strength in both nonresidential and residential fixed investment as well as a pickup in consumer spending following a sub-par performance in the second quarter (1.6% annual rate). Consumer spending was flat in August, in both nominal and real terms, but July was revised up substantially and strong sales of light vehicles bode well for the September consumption numbers. Thus, the third quarter is on pace to show a solid gain (around 4%) despite the August flatness.

The job market apparently remains in gear despite negative hurricane effects…

The labor market picture also has brightened, despite some obvious (and temporary) negatives from the recent rash of hurricanes. Revisions to the employment reports for both June and July confirmed that the mid-year “soft patch” was not as bad as earlier estimates had suggested. Furthermore, preliminary data show solid improvements in the job market during August, and weekly data on unemployment insurance claims point toward a good September as well (adjusted for the hurricanes).

In general, payroll employment is on the rise, the unemployment rate is edging down, average hours worked are on the rise and increases in average hourly earnings are contributing to growth in labor income. These developments, naturally, are positives for housing demand. [return to top]

The inflation front shows improvement despite oil price problems…

There’s also good news on the inflation front, despite gathering upward pressures on unit labor costs from the increases in hourly compensation and a cyclical slowdown in growth of labor productivity (output per hour). Recent turmoil in world oil markets certainly has boosted overall inflation rates, but core inflation (excluding prices of food and energy) actually has been receding from the elevated readings earlier this year.

Data released on Sept. 30 show that the Federal Reserve’s favorite inflation measure (the core price index for personal consumption expenditures) receded to a 1.4% year-over-year pace in both July and August, readings that are well within the Fed’s tolerance range. This news followed encouraging readings on the core Consumer Price Index for August. [return to top]

The Fed still is on track for another rate increase on November 10…

As expected, the Fed continued to ease off the monetary policy accelerator at the Sept. 21 meeting of the Federal Open Market Committee (FOMC), raising the federal funds rate target to 1.75%. At that time, the Fed described the risks to both sustainable economic growth and price stability as “balanced.” The Fed went on to characterize its monetary policy stance as “accommodative” and indicated that further rate increases would occur at a “measured” pace.

The recent news on GDP growth, the job market and core inflation presumably are consistent with Fed expectations. NAHB’s forecast shows a quarter-point rate hike at the Nov. 10 FOMC meeting and a funds rate of 3.75% by the end of next year. [return to top]

Long-term interest rates back up following a late-September disconnect…

Long-term interest rates have fallen since mid-year despite the 75 basis point increase in the federal funds rate since June 30. The bond-market rally was related to the apparent slowdown in economic growth (the “soft patch”), the fallback in core inflation rates and the Fed’s commitment to a “measured” path of adjustments back toward monetary neutrality. However, long-term rates appeared to disconnect from economic realities in late September, when the 10-year Treasury yield slipped below 4%.

Both bond and mortgage rates backed up a bit as September drew to a close, and some further increase has been recorded in the early days of October. NAHB’s forecast shows further (moderate) increases over the balance of this year and in 2005, a pattern that takes the long-term mortgage rate close to 7% by the end of next year. [return to top]

The single-family housing market still is riding high…

The housing market has been bolstered by a combination of stronger employment and household income growth and the surprising decline in long-term interest rates. Indeed, the demand for homes has been extraordinarily strong, recently driving home sales and single-family starts to record levels and stimulating the condominium market as well. Single-family home sales (new plus existing) spiked to a record 7.98 million annual rate in the second quarter and slipped by less than 2% in the July-August period.

Market activity may now be topping out, and NAHB’s forecast still shows modest erosion of home sales and housing production in the fourth quarter of this year and in 2005 — as the interest rate structure gravitates upward. If we’re right, 2005 will be the second best year on record for the single-family market, down about 5% from the 2004 highs. [return to top]

House prices continue to rise aggressively, but a slowdown is in the cards…

House prices accelerated upward as housing demand strengthened during the spring and summer. Repeat-sales price measures accelerated to nearly 10% (year-over-year) in the second quarter, and median prices for sales of new and existing homes in July and August remained at an elevated pace (7%-10% range).

This price performance has resurrected strident charges of house price “bubbles” in various markets around the country, and the bubble charges have been fueled by strong shifts toward adjustable-rate home mortgages, particularly in new-home markets located in the highest-priced areas of the U.S.

The shift toward ARMs should wane as the Fed raises short-term interest rates, and house price inflation should decelerate to a more sustainable pace before long. Indeed, anecdotal reports from some of the nation’s hottest housing markets suggest some buyer resistance, even at the recent low interest rate levels. [return to top]

Household balance sheets are in great shape, thanks largely to housing…

Strong rates of new-home production, a strong pace of remodeling activity and strong rates of house price appreciation have combined to push the market value of the owner-occupied housing stock to higher and higher records. The Federal Reserve estimates this value at $15.7 trillion at mid-2004, up by 12% from a year earlier and the largest component of household sector assets. Home owner equity was a record $8.6 trillion at mid-year, up by 12% from a year earlier despite heavy borrowing against it.

The aggregate housing debt-to-value ratio was 45% at mid-2004, up only slightly from the late 1990s despite massive cash-out refinancings and heavy home equity lending during the low interest rate environment of 2001-2004. Furthermore, the Fed’s financial obligations ratio for America’s home owners — defined as the ratio of debt payments, auto lease payments, payments for home owner insurance and property taxes to disposable personal income — was only 15.76% in the second quarter. That’s down from recent highs in late 2002 and early 2003 and well below a corresponding ratio for renter households of 30.09%.

It’s clear that the typical American household is not laboring under a heavy debt load, despite a rash of opinions to the contrary. Indeed, low mortgage delinquency and foreclosure rates show that mortgage credit quality is in very good shape. [return to top]

Oil markets threaten the outlook, but there’s an ace in the hole…

World oil markets obviously pose a threat to our favorable outlook for the U.S. economy and the housing sector, even though the economy is not nearly as vulnerable to oil price shocks as in past decades. Unfortunately, oil prices are very difficult to forecast, in view of the vulnerability of oil supplies to political instability and terrorism in key oil-producing regions of the world.

Fortunately, the Federal Reserve presumably is prepared to adjust monetary policy to help absorb any negative impacts of oil price shocks on U.S. economic growth. Fed tightening to head off inflationary consequences of oil price increases seems out of the question this time through. [return to top]