Eye on the Economy - 07/18/2007 (Plain Text Version)

By David F. Seiders, NAHB Chief Economist

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Economic Growth Has Rebounded From the First-Quarter Lull

Growth of real GDP for the first quarter of the year now stands at an annual rate of 0.7%, according to the “final” estimate released by the Commerce Department on June 28.

Residential fixed investment contracted at a 15.8% rate and subtracted 0.89 percentage point from GDP growth. Large negative contributions also came from net exports and business inventory investment. These drags held overall GDP growth to the slowest pace in more than four years and prompted a lot of speculation about near-term recession in the U.S. economy.

As we suspected, the first-quarter downshift in economic growth was a temporary phenomenon. Rebounds in net exports and business inventory investment, and a smaller drag from residential fixed investment, apparently helped raise GDP growth to about 3% in the second quarter (that’s our current estimate). Furthermore, we’re looking for near-trend growth performance over the balance of the 2007-2008 forecast horizon, and we place the probability of recession in a 20-25% range for this period – pretty normal for this stage of an economic expansion.

The Labor Market Still Is Generating Good Job Growth and Low Unemployment

The labor market performed well during the first half of the year despite the first-quarter downshift in GDP growth. Payroll job growth averaged 145,000 per month (with recent revisions), below the average pace in 2006 (189,000) but still quite respectable. The unemployment rate averaged 4.5% in the first half of 2007, presumably the low range for this cycle.

NAHB’s forecast shows a modest increase in the unemployment rate over the balance of the 2007-2008 forecast horizon, consistent with our projections for household employment and labor force growth. We’re also looking for average monthly payroll job gains of around 125,000, equivalent to employment growth of roughly 1% on an annualized basis – a sustainable pace at this stage of the economic expansion. [return to top]

Core Inflation Is Gradually Receding, Thanks Largely to Housing

Persistently tight labor market conditions have been putting persistent upward pressures on average hourly earnings, and a cyclical slowdown in productivity growth (output per hour) has contributed to upward pressures on unit labor costs. Despite these pressures, and despite renewed upward pressures on energy prices, measures of core consumer price inflation (excluding food and direct energy) have been remarkably well behaved in recent months. Indeed, the core PCE price index slipped to a year-over-year rate of 1.9% in May and the core CPI showed an advance of 2.2% for that month – readings that are within the Fed’s apparent “comfort zones” for these measures. Furthermore, the core CPI posted another relatively benign year-over-year gain in June (2.2%), and the technically superior chain-core CPI trailed down to a 1.8% pace.

The recent reductions in core consumer price inflation (both PCE and CPI versions) can be traced largely to slowdowns in growth of residential rents and the large imputed “owners’ equivalent rent” components. These slowdowns have been prompted by rising vacancy rates in rental housing, a pattern that’s been provoked partly by conversions of condominium developments to rental projects as home buying activity has weakened substantially.
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The Fed Holds Steady and Fusses About Inflation Pressures

As expected, the Federal Reserve held monetary policy steady at the June 28 FOMC meeting, maintaining the 5.25% federal funds rate target. The FOMC statement referred to “moderate” economic growth in the first half and noted that core inflation had been improving “modestly.” However, the Fed did not declare victory over inflation, pointing out that the high level of resource utilization (i.e., the low unemployment rate) has the potential to sustain inflationary pressures down the line.

NAHB’s forecast assumes that the Fed will hold the nominal funds rate steady over the balance of the 2007-2008 forecast horizon, allowing the real funds rate to gravitate upward as core inflation recedes further. Chairman Bernanke’s testimony in connection with the Fed’s Semiannual Monetary Policy Report to the Congress (delivered July 18 and 19 in the House and Senate) reinforces our expectations regarding our central bank’s preoccupation with upside risks to inflation and the prospects for monetary policy management over the short term. [return to top]

Long-Term Rates Firm Up, But Fixed-Rate Mortgages Regain Dominance

Long-term interest rates have been fluctuating a good bit in recent times, primarily in response to shifting market attitudes regarding U.S. economic growth, inflation and monetary policy management. Furthermore, rather persistent upward pressures on rates have been coming from abroad, reflecting upward inflation pressures in some key foreign economies and efforts by foreign central banks to control those pressures. NAHB’s forecast assumes that long-term rates will remain close to current levels during the second half of this year, with the 10-year Treasury yield hanging around 5.1% and the prime fixed-rate home mortgage hovering around 6.65%, and we anticipate only slight upward movements in 2008.

Despite emergence of a positive slope to the Treasury yield curve across most of its range along with maintenance of a stable relationship between yields on fixed-rate mortgages and 10-year Treasury securities, the role of adjustable-rate mortgages (ARMs) in financing home purchases recently has shrunk to an historic low (10% in May). Shrinkage of the ARM share has occurred as both financial regulators and market forces have imposed greater discipline on lending standards in ARM markets – particularly in the subprime and Alt-A components. [return to top]

The Housing Downswing Still Is Underway

The dramatic downward correction in U.S. housing markets has been underway for nearly two years. Single-family building permits topped out in the fall of 2005 and have declined by 43% since then (through June). Furthermore, NAHB’s single-family Housing Market Index hit a current-cycle low of 24 in early July, down from a peak of 72 in mid-2005. The HMI now is down by more than 50% in all four regions of the country, and all three component measures (current and expected sales as well as traffic of prospective buyers) now have values less than half their respective 2005 peaks.

NAHB’s proprietary survey of 32 large single-family builders (accounting for about 26% of single-family home sales last year) shows modest improvements in seasonally-adjusted gross and net sales in both May and June, presumably reflecting aggressive use of sales incentives (including price cuts) by the big companies. Despite these improvements, net sales in June were down by 43% from their mid-2005 peak and most of the big companies continue to talk about difficult market conditions – including subprime-related tightening of mortgage lending standards and recent increases in prime mortgage rates.

Despite the stunning dimensions of the housing correction to date, the single-family and condo housing markets still are coping with major imbalances that promise to maintain downward pressure on home buying and home building for some time. First, affordability remains historically low, a problem that’s been aggravated by tighter lending standards in connection with the subprime mortgage debacle and the recent firming-up of prime mortgage rates. Second, inventories of vacant homes for sale (new and existing) have climbed to record highs, boosted by homes put back on the market by investors/speculators that had gobbled them up during the 2003-2005 buying frenzy. [return to top]

The Housing Market May Bottom-Out by Year-End

A nationwide survey of more than 400 single-family builders, conducted by NAHB in June, sought to gauge market momentum at mid-year and to identify builders’ production plans for the second half of 2007. The survey highlighted the adverse impacts of the subprime-related mortgage crisis on sales and cancellations as well as builders’ efforts to adjust to a deteriorating market environment.

The patterns of responses to our mid-year survey definitely point toward some further erosion of single-family starts during the second half of the year, although it’s pretty clear that the bulk of the downswing already is behind us. NAHB’s current forecast for the second half shows a 5% decline in single-family starts from the first-half pace, bottoming out in the fourth quarter at an annual rate of 1.1 million units – 37% below the quarterly peak for this housing cycle. We expect multifamily starts to be down by about 6% in the second half, bottoming out at 270,000 units in the fourth quarter – 28% below the recent peak early last year. [return to top]

2008 Stacks Up as a Year of Modest Recovery

Although we expect most housing aggregates to bottom-out by the end of this year, the projected recoveries in 2008 produce only modest year-over-year gains. In this regard, NAHB’s forecasts for 2007-2008 show the following broad patterns for the key components of housing production:

23% decline in single-family starts in 2007, followed by a 2% recovery in 2008.
16% decline in multifamily starts in 2007, followed by another 2% decline in 2008 as the condo market weakens further.
19% decline in manufactured home shipments in 2007, followed by a 10% recovery in 2008 from a historically low level.
2% declines in the real value of residential remodeling in both 2007 and 2008, driven by 5% declines in improvements – particularly on owner-occupied housing.
14% decline in real Residential Fixed Investment in 2007, followed by a 1% recovery in 2008.

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...But Risks and Uncertainties Abound

It must be recognized that NAHB’s baseline (most probable) housing forecasts for the second half of 2007 and 2008 are surrounded by sizeable risk bands associated with unique features of the frenetic housing boom of 2003-2005 and the dramatic aftermath that’s still unfolding. At this point, major uncertainties surround the true dimensions of the current and prospective overhang of vacant (new and existing) housing units on the market, the degree to which mortgage lending standards will tighten as that pendulum continues to swing back, and the effects of declining home prices on the behavior of prospective home buyers.

The Fed’s Semiannual Monetary Policy Report to the Congress identified the housing market as the key downside risk to the Fed’s outlook for the U.S. economy: “On the downside, the fall in housing construction could intensify or last longer than expected. In addition, persistent weakness in the housing sector could spill over to other sectors, especially consumption.” We certainly share those concerns! [return to top]