June 28, 2006
By David F. Seiders
NAHB Chief Economist
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Inflation is now the number one economic issue for the U.S.
An extended period of above-trend economic growth, along with associated shrinkage of slack in U.S. labor markets, has generated growing concern on the inflation front.

The Fed is increasingly 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 have been making their way into the core through business cost structures.

Core inflation readings for the first quarter of 2006 were reasonably well contained, at least on a year-over-year basis, although various measures definitely firmed up on a quarter-to-quarter basis.  Furthermore, available data for April and May show further acceleration.  The core Consumer Price Index definitely is on an upward path, showing year-over-year increases of 2.3 and 2.4% in April and May, respectively – not far below our estimate of the upper bound of the Fed’s tolerance zone for this inflation measure (2.5%).  The technically superior chain-core CPI (allowing for substitution among goods and services in the market basket) also has been accelerating in recent months, posting a year-over-year gain of 2.2% in May.

A weakening housing market is generating “inflationary” pressures
Sizeable portions of the recent increases in core consumer price inflation represent large increases in the housing components of these inflation measures.  The housing components, in turn, have been driven primarily by government imputations for “owners’ equivalent rent of primary residences.” This component accounts for 30% of the core CPI, it registered a 3.3% year-over-year gain in May, and the annualized monthly gain was nearly 8%!

The surge in owners’ equivalent rent reflects rising rental rates that are not actually borne by the nation’s homeowners, and a good case can be made to exclude this imputed component from the analysis of inflation trends.  Indeed, the upshift in rental rates is associated with the systematic weakening of single-family and condo markets that is being provoked by Federal Reserve rate hikes. That makes tighter monetary policy inflationary, a perverse effect that should be discounted by the Fed! [return to top]

The Fed is now deliberating our economic future
The Federal Open Market Committee (FOMC) is meeting today and tomorrow at the Fed's headquarters in Washington, D.C. The Fed is assessing the condition of the U.S. economy, including the balance of risks to both sustainable economic growth and price stability, and any changes to monetary policy will be announced at the conclusion of the meeting (around 2:15 tomorrow afternoon).

Tomorrow's FOMC statement undoubtedly will stress the threats to ongoing economic growth from the recent increases in key measures of core inflation, with emphasis on the recent acceleration of the core CPI. And although the FOMC certainly understands the rather perverse "inflationary" impulse being generated by the housing component of the CPI, the Fed is not likely to qualify its inflation concerns on these grounds.

The Fed's inflation concerns almost certainly will provoke yet another upward adjustment to short-term rates at the conclusion of tomorrow's meeting; some market participants anticipate a half-point increase in the federal funds rate target, but a quarter-point hike (to 5.25%) is the best bet. The wording of tomorrow's FOMC statement could give important clues regarding advance planning for the next FOMC meeting on August 8. Although the statement will continue to say that future policy adjustments will be heavily data-dependent, it seems clear that the Bernanke-led FOMC is leaning toward at least one more rate hike in 2006 – despite the perverse impact of housing on the core inflation numbers. [return to top]

Recent housing data are a mixed bag
The Federal Reserve fully expects the housing market to cool down this year, partly in response to the series of rate increases implemented by the Fed.  Public statements by Fed officials characterize the evolving housing slowdown as “moderate” and “orderly” – a pattern consistent with NAHB’s baseline (most probable) forecast.

NAHB has been warning the Fed about large downsize risks to our respective baseline forecasts for housing.  These risks are associated largely with major uncertainties regarding the behavior of investors/speculators that were such a major factor on the demand sides of single-family and condo markets in 2004 – 2005.

NAHB’s surveys of builders show deepening problems in the single-family market through June, including cancellations and resales by investors/speculators.  Ongoing erosion in single-family and condo markets also is shown by sales/price data for the existing-home market (from the National Association of Realtors), and the weekly series on applications for mortgages to buy homes (from the Mortgage Bankers Association) still is rattling downward.  We’re also seeing a distinct downslide in issuance of single-family building permits (data through May).

Conflicting (positive) signals are coming from the May data reported by the Commerce Department for both single-family housing starts and sales of new homes.  Indeed, the starts numbers were up by 2.1% in May and new-home sales were up by 4.6% — in the face of reports from public builders and NAHB’s surveys showing ongoing erosion of housing demand. [return to top]

Fundamentals still point to a cooling housing market
The apparent conflicts in housing data apparently reflect, to a large measure, deficiencies in the government’s data collection procedures (particularly for new-home sales).  It’s also apparent, however, that a fair number of single-family starts recently have reflected building against permits backlogged earlier, and we also know that builders have been strengthening both price and non-price incentives to bolster new sales and limit cancellations of sales contracts signed earlier.

Everything considered, it’s fair to say that single-family and condo markets still are cooling down in fundamental ways and that the housing slowdown still has some distance to run.  NAHB’s forecast continues to show an 8% decline in total housing starts for 2006 as a whole, with relatively large reversals in the single-family and condo markets along with further firming-up of rental markets. [return to top]

For more information or to contact us directly, please visit www.NAHB.org l ©2006, National Association of Home Builders

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