May 17, 2006
By David F. Seiders
NAHB Chief Economist
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Economic Growth Is Slowing Down in the Second Quarter
The Commerce Department's "advance" estimate of real Gross Domestic Product (GDP) for the first quarter of this year showed robust 4.8% growth, well above sustainable trend growth.

Furthermore, data received since then for construction activity, business inventory investment and the trade balance in March point toward a substantial upward revision (toward 6%) when the "preliminary" estimate for the first quarter is released on May 25.

Fortunately, GDP growth is slowing toward a more sustainable pace in the second quarter. NAHB's forecast currently shows 3.4% growth, and data in hand (including housing starts for April) suggest that growth could be even slower than that. In any case, the U.S. economy definitely is slowing down at this time, and we continue to expect a pattern of below-trend growth (around 3%) in the second half of this year and in 2007. That's actually a positive development, since a slowdown is essential to prevent overheating of the economy and an eventual rough landing.

The Growth Slowdown Should Keep the Labor Market From Tightening Further
Nearly three years of average above-trend GDP growth have generated solid growth in employment and systematically reduced the degree of slack in U.S. labor markets — demonstrated by a falling unemployment rate from the cyclical high in mid-2003.

The unemployment rate held at an expansion low of 4.7% in April, but employment growth was somewhat disappointing (a gain of 138,000). Employment growth has been quite volatile on a month-to-month basis, of course, and the April reading followed above-trend gains in both February and March. Furthermore, both average weekly hours and average hourly earnings showed solid gains in April. Everything considered, underlying conditions in the labor market remained firm in April.

The evolving slowdown in GDP growth will prevent the unemployment rate from falling much (if any) further in the near term, and NAHB's forecast shows an upward drift during the second half of this year and in 2007. While this may sound like an adverse development, some loosening of labor market conditions probably is essential to maintenance of an economic expansion with low inflation in coming years. [return to top]

Core Inflation Is Now Close to the Upper End of the Fed's "Tolerance Zone"
The extended period of above-trend GDP growth and associated shrinkage of slack in U.S. labor markets has generated growing concern on the inflation front. Indeed, the Fed has been quite worried about upward pressures on "core" inflation (excluding prices of food and energy) from tightening labor markets as well as from soaring energy prices that inevitably make their way into the core through business cost structures.

Core inflation readings for the first quarter of 2006 were reasonably well contained, although various measures definitely were in the process of firming up. Furthermore, available data for April show some further acceleration. The core Producer Price Index for finished goods was benign in April, but the core PPIs at earlier stages of production showed more substantial increases. The core Consumer Price Index definitely is on an upward path, showing annualized increases of 3.6% in both March and April. The April reading was up by 2.3% on a year-over-year basis, not far below our estimate of the upper bound of the Fed's tolerance zone for this inflation measure (2.5%).   [return to top]

The Fed Hikes Short-Term Rates Again and Frets About Inflation Pressures
As expected, the Fed enacted another quarter-point increase in short-term interest rates at the conclusion of the May 10 meeting of the Federal Open Market Committee (FOMC), raising the federal funds rate target to 5%. This was the 16th consecutive quarter-point rate hike since mid-2004.

The FOMC statement took note of the strong GDP growth pattern early this year but expressed an expectation of slower growth in the near term, "partly reflecting a gradual cooling of the housing market." The statement also noted that core inflation was well-contained in the first quarter, while stressing that "possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures."

With respect to future policy moves, the FOMC statement said that "some further policy firming may yet be needed to address inflation risks," but the statement also emphasized that future policy moves will be highly data-dependent. Our current forecast assumes that the Fed will hold the current policy stance for some time, with a nominal funds rate of 5% and a "real" rate around 3%. However, evidence of slowing economic growth and benign core inflation will have to be convincing to hold off yet another quarter-point rate hike at the next FOMC meeting on June 29. The April reading on core CPI inflation certainly has tilted the odds toward at least one more rate hike this year. [return to top]

Long-Term Rates Are at 4-Year Highs and May Be Heading Higher
Long-term interest rates fell during the first year of the Fed's extended rate-hike process, provoking former Fed Chairman Alan Greenspan to declare a "conundrum" in fixed-income markets about a year ago. However, long-term rates rose to some degree during the second half of 2005 and they have moved decisively higher so far this year. Indeed, long-term rates now are at 4-year highs and the Treasury yield curve now has a significant upward slope despite the Fed's ongoing process of short-term rate hikes.

Expectations of future monetary policy adjustments, as well as inflation expectations, are built into the current yield structure, and the future course of long rates will depend on how well actual developments square with those expectations. NAHB's forecast allows for a slight further rise in 10-year Treasury yields this year (to 5.2%), and we're showing a similar rise in the fixed-rate home mortgage yield (to 6.7%). This forecast is contingent on a slowdown in economic growth, a slowdown in employment growth, an uptick in the unemployment rate, containment of core inflation and maintenance of a 5% funds rate. While the slowdown in growth appears to be underway and the labor markets may loosen before long, the inflation picture seems to be deteriorating and the odds of another Fed rate hike have just risen.  [return to top]

Consumer Sentiment Recedes and Home Builder Sentiment Contracts Further
Our projected slowdown in economic activity is concentrated in household spending on consumer goods and housing, and both are vulnerable to high energy costs and rising interest rates. Indeed, these two components of the economy are closely linked since consumer spending on things like furniture and appliances is connected to home sales, and overall consumer spending is related to wealth creation generated by house price increases.

The University of Michigan's preliminary consumer sentiment index for May fell sharply as Americans fretted over climbing gasoline prices and worried about future economic conditions. Indeed, the decline was the sharpest since the reversal provoked by hurricanes Katrina and Rita last year.

Builder confidence also fell substantially in May, continuing the pattern of erosion begun last July. Indeed, NAHB's single-family Housing Market Index fell to 45, the lowest reading since mid-1995. Ironically, the 1995 episode represented a mid-cycle "correction" provoked largely by the Fed's efforts to rein in that expansion and extend its life. The motivation behind current monetary policy management appears to be essentially the same. [return to top]

Housing Starts and Permits Move Down Convincingly in April
Housing starts hit a cyclical high in the first quarter of this year, despite the obvious deterioration in indicators of housing demand from the highs of last year (including our HMI) and well-documented increases in both sales cancellations and unsold inventories. This apparent disconnect could be pinned partly on the impacts of unusually good winter weather on the starts pattern as well as on large backlogs of orders that builders were still building out. However, the rising cancellations and inventories stuck out as emerging trouble signs!

Fortunately, housing starts and permit issuance moved down convincingly in April — by 7.4% and 5.4%, respectively. These declines reflected a natural pay-back for the weather-related surges in the first quarter as well as builder adjustments to eroding demand and rising inventories. [return to top]

NAHB's Housing Forecast Is Basically On Track
We continue to believe that the evolving housing slowdown essentially constitutes a moderate adjustment toward more sustainable levels of production, following the record surge in 2005 that was fueled by extraordinary demand for single-family homes and condo units by investors/speculators. So far, total housing starts are down by nearly 1% on a year-to-date basis, and NAHB's forecast continues to show a 6.1% decline in total housing starts for 2006 as a whole — following an equivalent increase last year. We're projecting relatively large declines for single-family starts and the condo component of multifamily starts. [return to top]

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