The Seiders' Report, May 2006
• We continue to believe that the evolving housing slowdown will be a moderate adjustment process, in the context of the economic and financial market environment we’re projecting for 2006-2007. However, the adjustment could turn out to be pretty rough in some previously overheated markets, and there are significant downside risks to our baseline (most probable) national forecasts through next year. The biggest risks relate to the behavior of investors/speculators in the single-family and condo markets.
• Growth of U.S. economic output (real GDP) rebounded strongly in the first quarter following a hurricane-related slowdown late last year. The rebound extended the current economic expansion into its fifth consecutive year and maintained the average above-trend growth path that’s prevailed for nearly three years.
• The extended run of above-trend GDP growth has generated strong growth in payroll employment and systematic declines in the unemployment rate since mid-2003, despite maintenance of solid growth in labor productivity (output per hour).
• The strength of the economic expansion has been reducing slack in U.S. resource markets, demonstrated by falling unemployment rates and rising rates of capacity utilization in our industrial sector. These developments have raised inflation concerns at our central bank, and record-high energy costs have added to those concerns.
• Key measures of “core” inflation (excluding prices of food and energy) have been reasonably well-behaved so far. However, rising unit labor costs and an inevitable pass-through of energy costs promise some further upward pressure on core inflation as the economic expansion rolls along.
• The Federal Reserve has been fretting about gathering inflation pressures for some time, and recent core inflation rates are close to the upper end of the Fed’s apparent “tolerance zone.” Indeed, the threat of inflation was the key factor behind the quarter-point increase in the federal funds rate at the May 10 meeting of the Federal Open Market Committee.
• The statement issued at the conclusion of the May 10 FOMC meeting reinforced the Fed’s anti-inflation resolve but emphasized that future monetary policy adjustments will be highly data-dependent. The Fed wants to see a slowdown in economic growth, more slack in labor markets, firm limits on unit labor costs and containment of inflation expectations —key factors behind core inflation down the line.
• GDP growth is slowing to some degree in the second quarter, and we expect growth to slip below trend during the second half of this year and in 2007 —resulting in slower employment growth, a slightly higher unemployment rate and containment of core inflation. These patterns, if realized, will encourage the Fed to maintain the current monetary policy stance for some time.
• Long-term interest rates have moved up decisively since early this year, rising to 4-year highs in the process. We’re expecting only modest further increases over the balance of the year, assuming the Fed holds monetary policy steady from here on out, and the Treasury yield curve should maintain a slight upward slope across the forecast horizon (a healthy development).
• Affordability problems caused by years of rapid home price appreciation began to take a toll on housing demand around the middle of last year, and the rising interest rate structure has further reduced affordability and prompted cutbacks in investor/speculator activity as well. We’re now seeing falling home sales, rising cancellations, rising inventories and slowing rates of house price appreciation —all in line with our expectations.
• The longer-term outlook for housing is excellent. A combination of strong household formations, large replacement needs and a vital second-home market will generate demand for 2.1 million new housing units per year (on average) for the 2005-2014 period, the highest 10-year period on record. The remodeling market also will be hitting higher and higher records on a trend basis.
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