June 15, 2005
By David F. Seiders
NAHB Chief Economist
 
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The national economy is moving ahead nicely despite some uneven sectoral performances …
On June 9, Federal Reserve Chairman Alan Greenspan told the Joint Economic Committee of Congress that “the U.S. economy seems to be on reasonably firm footing,” while noting that: “Over the past year, the pace of economic activity in the United States has alternately paused and quickened.” He stressed that the soft readings on the economy observed in the early spring “were not presaging a more serious slowdown in the pace of activity.”

Growth of real Gross Domestic Product (GDP) for the first quarter now stands at 3.5%, and some further upward revision is likely. Available monthly data for the second quarter point to maintenance of GDP growth around 3.5%, and that’s enough to generate further improvements in the labor market.
 

 
The job market still is functioning well despite some disappointing signs …
Payroll employment increased by 78,000 in May, according to the preliminary report released by the Labor Department on June 3. This gain was smaller than generally expected (the consensus called for 175,000), but the result was not truly alarming. The large April increase (274,000) was left unrevised and the month-to-month pattern has shown a lot of volatility for some time. The average gain was 176,000 for the April-May period, 180,000 on a year-to-date basis and 165,000 over the past 12 months. From this point of view, the trend in payroll job growth looks intact and trend growth in aggregate hours worked is adequate to support our GDP estimate for the second quarter.

The portion of the May employment report that’s based on a survey of households (rather than business establishments) hardly showed weakness in May. Indeed, the gain in household employment was substantial (376,000) and the unemployment rate ticked down to 5.1 percent as the labor force rose by 360,000 and the labor force participation rate edged up for the second month in the row. The return of previously discouraged workers to the labor force is helping to maintain ample slack in the labor market, and we’re counting on this dynamic to support further above-trend growth in economic output. [return to top]
 

 
Core inflation sags in May ― and that’s great news …
Global oil prices and the cost of gasoline at the pump have come off their April peaks, reducing threats to the ongoing economic expansion as well as threats to “core” inflation (excluding prices of food and energy) in the U.S. Inevitable “leakage” of oil and gas prices into core consumer prices has been on the minds of officials at our central bank, and the recent sag of energy prices certainly is welcome news. So is a recent retreat in non-oil commodity prices.

The news on producer and consumer price inflation for May was quite reassuring in its own right. The Producer Price Index (PPI) for finished goods fell sharply in May as energy costs plummeted and the core component of the PPI showed a year-over-year advance of 2.6% — the same as March and April and below the February pace. The Consumer Price Index (CPI) also fell in May, reflecting a sharp decline in energy prices, and the core CPI was up by only 2.2% on a year-over-year basis. The technically superior chain-core CPI showed only a 1.8% gain, the slowest since last October and with the Fed’s apparent “comfort zone.” [return to top]
 

 
The Fed is poised to hike short-term rates again on June 30 …
Minutes from the May 3 meeting of the Federal Open Market Committee (FOMC) revealed ongoing preoccupation with upside risks to the inflation outlook as the economic expansion moves forward and slack in resource markets is reduced in the process. The minutes also make it perfectly clear that the Fed still views its monetary policy stance as too easy, despite the substantial increase in the federal funds rate implemented since mid-2004 (two percentage points).

The minutes say that all FOMC members “regarded the stance of monetary policy as accommodative and judged that the current level of short-term rates remained too low to be consistent with sustainable growth and stable prices in the long run.” Indeed, the real (inflation-adjusted) funds rate is only about 1%, and history shows that such a policy stance is not sustainable over time.

The evaporation of the early-year “soft spot” in the economic expansion gave the Fed some leeway to accelerate its march back to monetary “neutrality” but positive news on core inflation has lessened the urgency of such a march ― keeping our central bank to a “measured pace” of adjustments.

Most recently, newfound signs of weakness in the manufacturing sector argue for a cautious monetary policy approach while the upswing in unit labor costs argues for ongoing diligence in the fight against inflation.

Again, the balance of forces suggests adherence to slow but steady removal of policy stimulus from the economy. A quarter-point increase in the federal funds rate is in the cards at the June 29-30 FOMC meeting. [return to top]
 

 
We’re still in the middle innings of the Fed’s ball game …
The markets were thrown for a loop on June 2 when Richard Fisher, the new president of the Federal Reserve Bank of Dallas and a voting member of the FOMC, said on national television that the Fed is in the “eighth inning” of monetary tightening (having implemented eight consecutive quarter-point increases in the federal funds rate since mid-2004), and that the next FOMC meeting (June 29-30) will be the “ninth inning” in the central bank’s “contest against inflation.”

The markets bought into the idea that the Fed is quite close to the end of the tightening cycle, despite Fisher’s newness to the public relations game and recent statements by other Federal Reserve officials suggesting that the tightening cycle still has some time to run. Futures markets immediately marked down expectations for the federal funds rate later in the year and longer-term interest rates fell as well.

Fisher’s baseball analogy probably did not set well with Greenspan and the majority of FOMC members, and the Fed chairman brushed off the notion in his June 9 testimony before the Joint Economic Committee. NAHB’s forecast still assumes the Fed will continue to move ahead at a determined but “measured” pace, taking the federal funds rate to 4% by year end (pegging the bank prime rate at 7%). Some further increase may very well occur in 2006 as long as the economic expansion continues to generate upward pressure on unit labor costs and core inflation. [return to top]
 

 
Long-term interest rates are still below sustainable levels …
Long-term interest rates moved downward a good bit in recent weeks, pushing the 10-year Treasury yield below 4% and the fixed-rate home mortgage yield to about 5.6% in the early days of June. These rates have moved upward to some degree in recent days but remain well below the levels of mid-2004 when the Fed embarked on its determined march back to monetary neutrality.

While reasonably solid domestic and global fundamentals can pretty much account for the behavior of long-term rates since mid-2004, the bond market rally of late May and early June had weak underpinnings. The markets apparently bought into the flimsy notion that the economy is now flagging (because of manufacturing) and that the job market is now weakening (because of payroll employment in May) while ignoring the inflationary consequences of surging unit labor costs. And, for whatever reason, the markets seemed to accept Fisher’s colorful baseball remarks as an accurate picture of Federal Reserve plans and intentions. Extra icing for the cake was provided by an extra surge of investment capital into the Treasury market in the wake of collapse of the constitutional initiative in the European Union (both France and the Netherlands voted “no” during the week of May 29).

It’s possible that recent downward pressures on long-term interest rates will persist as the economic expansion moves forward. But it’s more likely that the expansion will generate stronger upward pressures on core inflation (primarily from rising unit labor costs) and that ongoing Fed tightening ultimately will push short- and long-term rates in the same direction.

NAHB’s forecast currently shows roughly half-point increases in long-term rates by late in the year, half the projected increase in the federal funds rate but enough to keep the Treasury yield curve from inverting. [return to top]
 

 
The housing market still is in high gear …
The recent economic and financial market environment has been quite hospitable for the housing sector, and a spate of highly aggressive mortgage finance products has supported housing demand in markets where affordability has been strained by rapid increases in house prices. Indeed, the interest-sensitive housing sector has remained the hottest part of the U.S. economy despite the pattern of Fed tightening since mid-2004.

Upbeat news on housing for April includes record levels of single-family home sales, soaring condo/co-op sales, yet another housing starts number on the north side of 2 million units and another solid increase in residential construction put-in-place. Year-to-date readings are up substantially for sales, starts and construction activity.

NAHB’s first-quarter Multifamily and Remodeling Market Indexes (based on surveys of apartment producers and managers as well as professional remodelers) show that these housing components are moving ahead nicely as well, and patterns of construction spending through April show great strength in these areas. The manufactured home market is the only weak spot in the housing sector.

Surveys of builders and mortgage lenders show that robust housing market activity extended into June. NAHB’s Housing Market Index (based on surveys of single-family builders) edged up to 71 in June, at the top of the range that’s prevailed for more than a year. Furthermore, the index of applications for mortgages to buy homes (Mortgage Bankers Association series) moved up to a record level in the week ending June 10. [return to top]
 

 
And we’re now headed for another record year …
It’s now highly likely that home sales and housing production in 2005 will surpass the records set last year, even if the interest rate structure moves up as in our forecast. Indeed, NAHB’s housing forecasts have just been revised upward, even though we’ve retained a modest fade in sales and starts in the second half of this year as well as in 2006. As a result, housing production remains historically high but moves out of the GDP growth-engine category after mid-2004, following a remarkably strong run that began at the end of 2001. [return to top]
 

 
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For more details, go to www.housingeconomics.com. [return to top]
 

For more information or to contact us directly, please visit www.NAHB.org l ©2005, National Association of Home Builders

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