Strong growth of U.S. economic output carries over to 2005 …
Back on Jan. 28, the Commerce Department released a surprisingly weak 3.1% “advance” reading for growth of real Gross Domestic Product (GDP) in the final quarter of 2004. However, an acknowledged error in foreign trade data for November, along with better-than-expected December readings for construction and exports, point toward a substantial upward revision when the “preliminary” report on fourth-quarter GDP is released on Feb. 25. We’re estimating 3.9%, about the same as our own advance estimate.

Strong economic growth apparently extended into the early part of 2005. Indeed, available monthly data for January ― including robust readings for retail sales, housing starts and building permits, and aircraft deliveries and orders — point toward maintenance of GDP growth around 4%, even higher than our current official forecast (3.6%).

The job market continues to improve as output growth moves ahead …
The ongoing growth in aggregate demand and economic output continues to generate improvements in the nation’s labor market, a process that’s now being supported by a cyclical slowdown in growth of labor productivity (output per hour).

Indeed, productivity growth in the nonfarm business sector slowed a good bit in the second half of 2004, falling to a year-over-year pace of 2.5% by the fourth quarter. This dynamic helped generate highly respectable monthly average payroll employment gains (182,000) during the final quarter of 2004.

Job growth slowed down a bit in January, showing a gain of 146,000. But unusually bad weather in several regions of the country apparently depressed seasonally adjusted growth by as much as 50,000 jobs, and construction employment fell by 10,000 following an extended period of solid growth. Everything considered, we’re anticipating first-quarter job growth to be about on par with the solid performance of the final quarter of 2004. [return to top]

Core inflation moves up at both the producer and consumer levels …
Core inflation in the U.S. (excluding prices of food and energy) certainly has firmed up since late 2003, although the readings for late-2004 still were historically low ― particularly for an economic expansion with three full years under its belt. The key measures of core inflation at the consumer level posted year-over-year increases of less than 2% in December, well within our estimate of the Federal Reserve’s “tolerance zone.”

This pleasant pattern apparently was violated by a January surge in the core component of the Producer Price Index (PPI) for finished goods. The surge was broad-based and raised the year-over-year gain to 2.7%, up from zero as recently as September of 2003. Although the Fed is not directly concerned with PPI inflation, the January reading undoubtedly got the attention of our central bank.

The Fed is well aware of upward inflation pressures emanating from tightening labor markets, rising unit labor costs, rising import prices and some pass-through of high energy prices, and rising producer prices certainly can make their way into consumer prices with some time lag.

The core Consumer Price Index (CPI) for January (released today) showed a year-over-year advance of 2.3%, and the technically superior chain-core CPI was up by 1.9%. These readings are consistent with the systematic upward pressures evident since late 2003, and there’s no doubt that the inflation issue is in sharp focus at the Federal Reserve. [return to top]

Fed policymakers have a positive outlook for economic performance in 2005-2006 …
Fed Chairman Alan Greenspan delivered the Federal Reserve’s semiannual Monetary Policy Report to the Congress on Feb. 16 (to the Senate) and Feb. 17 (to the House of Representatives). Greenspan painted an optimistic picture of the current condition of the economy as well as near-term prospects. In general, Greenspan talked about solid economic fundamentals, good economic growth, declining unemployment and modest increases in core measures of consumer prices.

The Fed’s report to the Congress also presented economic projections by monetary policymakers (Federal Reserve governors and Reserve Bank presidents) for the 2005-2006 period. The central tendencies of those projections show solid growth in real GDP, a gradually declining unemployment rate, and maintenance of core consumer price inflation below 2%. These projections, which can be interpreted as Federal Reserve intentions, are quite similar to NAHB’s forecasts for 2005-2006. One thing we don’t know, of course, is the monetary policy assumptions behind the Fed’s own projections. [return to top]

Short-term interest rates are heading higher for some time …
Greenspan certainly didn’t spell out the future path of monetary policy at his Feb. 16-17 testimony before Congress — he never does. However, a judicious reading “between the lines” reveals a strong preference for more tightening in the near term as well as further down the line.

In this regard, Greenspan described the federal funds rate as “fairly low” despite significant tightening since mid-2004, and he made several references to excessive risk-taking in financial markets. He also focused on upside risks to core inflation, including the slowing of productivity growth and the prospects for further declines in the dollar and rising import prices.

Financial markets are pricing in expectations of another percentage-point increase in the federal funds rate by year end, taking the funds rate to 3.5% and the bank prime rate to 6.5%. NAHB’s forecast shows even larger increases by year end, to 3.75% and 6.75%, and we believe the Fed will push the funds rate to 4.25% by mid-2006 as it pursues a neutral policy stance that will neither stimulate nor retard the economic expansion. [return to top]

Greenspan describes stubbornly low levels of long-term rates as a ‘conundrum’ …
When Greenspan marched to Capitol Hill on Feb. 16, the 10-year Treasury bond yield was hanging around 4.1%, well below the levels of mid-2004 despite the Fed’s 150 basis point hike in short-term rates that began on June 30. Greenspan naturally paid a good bit of attention to this apparent disconnect, and he pointed out that the phenomenon actually is global. In essence, he threw up his hands and said “the broadly unanticipated behavior of world bond markets remains a conundrum” — i.e., a riddle with no satisfactory solution.

Although Greespan was hard-pressed to explain the behavior of long-term rates, it seemed clear that he was not entirely happy with their stubbornly low levels ― since low rates and ample liquidity presumably are not consistent with stable core inflation over the longer term.

Greenspan’s vibrations apparently made their way into the bond markets, and the 10-year Treasury yield has gravitated toward 4.3%, in alignment with NAHB’s forecast for this point in time. We also continue to believe that further increases are in store, and we’re pegging the Treasury bond rate at 5% by year end. That move should take the long-term home mortgage rate up to about 6.5%. [return to top]

The housing outlook remains quite bright even with higher interest rates …
The housing market started out 2005 with a bang. Total housing starts for January posted a 21-year high, single-family starts climbed to a record high and issuance of building permits threatened the records set last May — and all this happened in the face of unusually bad weather in the Northeast, Midwest and West. Furthermore, the NAHB/Wells Fargo Housing Market Index continued to ride high in both January and February as builders maintained an upbeat view of buyer traffic, current home sales and sales prospects for the future.

These housing market signals, of course, were registered while long-term rates still were a “conundrum” and before the long rates started to firm up in the wake of Greenspan’s testimony. But long rates still are historically low, and it’s perfectly clear that the lending community is pulling out the stops when it comes to creative adjustable-rate mortgage products that stretch the affordability envelope ― particularly in places where rising house prices really threaten affordability.

Our forecasts for the economy and the financial market environment actually paint a friendly picture for housing in 2005 and 2006. We’re showing modest (3%-4%) declines in home sales and housing starts in both years, countered to some degree by persistent growth in residential remodeling and an evolving upswing in manufactured home shipments. The balance of forces generates slight declines in the residential fixed investment component of GDP over the next five to six quarters, following strong growth during the past several years (including the first quarter of this year). [return to top]

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