Eye on the Economy - 11/09/2005

Growth of U.S. economic output (real GDP) strengthened in the third quarter despite Katrina-related disruptions in September. Furthermore, recent data point toward an upward revision to third-quarter GDP growth, including a larger contribution from the housing production component of the economy (residential fixed investment).

The hurricanes (Katrina, Rita and Wilma) have certainly taken some toll on economic activity, and GDP growth is slowing to some degree in the fourth quarter. However, economic growth should strengthen early next year as rebuilding activities add to an economy that still has strong underlying momentum.

Labor market data are mixed, but consistently positive signals will reemerge soon…

Strong economic growth momentum has been generating systematic improvements in U.S. labor markets since the fall of 2003, despite maintenance of historically high rates of productivity growth (output per hour). The hurricanes definitely disrupted measurement of labor market conditions in both September and October, and it’s possible that the recorded slowdown in national job growth reflects more fundamental factors as well. But it’s more likely that fundamental trends in labor markets are still intact.

Payroll employment growth was quite limited in October (56,000) and revisions for the August-September period reduced the previously estimated employment level by 35,000. On the other hand, the household employment survey for October threw off positive signals. The labor force showed little change while civilian employment increased by 214,000, dropping the unemployment rate back to 5.0%.

Labor market data obviously present quite a puzzle at this time, even before consideration of weekly data on initial and continuing claims for unemployment insurance. We believe that labor markets still are in fundamentally good shape (partly because of the claims data) and that forward momentum in the economy will soon restore pre-hurricane rates of payroll job growth. In this environment, the unemployment rate should hang around 5% as growth in the labor force keeps pace.

Energy prices spur broad inflation measures, but “core” inflation remains benign…

Surging energy costs drove broad measures of inflation sharply upward in September; indeed, the producer price index for finished goods (PPI) increased at an annual rate of 25% while the consumer price index (CPI) increased at a 16% annual rate. However, key measures of core inflation (excluding prices of food and energy) remained much more subdued, within the historically low ranges prevailing since early this year.

Despite recent readings, the Fed and the markets are focusing hard on several factors that could generate increases in core inflation not far down the line. These include gradual shrinkage of slack in labor markets, an evolving slowdown in productivity growth, and likely leakage of high energy costs into core inflation. On the latter point, Chairman Greenspan recently reminded Congress of the destructive increase in core inflation that was associated with the surge of energy prices in the 1970s — an inflation issue that the Fed (under Arthur Burns) had handled badly. Our central bank is determined to prevent an energy-price induced rise in inflation expectations this time, though. [return to top]

The Fed tightens further and signals that there’s more to come…

The Fed enacted another quarter-point increase in short-term interest rates at the Nov. 1 meeting of the Federal Open Market Committee, a move that took the federal funds rate target to 4.0% and the bank prime rate to 7.0%. Furthermore, the FOMC statement noted that monetary policy remains accommodative (even after the rate adjustment) and that remaining policy accommodation can be removed at a “measured pace.”

Another quarter-point rate hike is a virtual certainty at the next FOMC meeting on December 13, and some further increase is likely down the line. Our forecast shows a funds rate of 4.5% at the conclusion of the Jan. 31 FOMC meeting, with stable policy over the balance of the short-term forecast horizon. It’s difficult to predict when the Fed will consider monetary policy to be neutral, however, particularly under a new Fed Chairman (Ben Bernanke) with a well-known bent toward explicit inflation targets for the central bank. [return to top]

Long-term interest rates have firmed up considerably in recent times…

Gathering expectations of future Fed actions as well as growing concerns about evolving upward pressures on core inflation have put significant upward pressure on long-term interest rates in recent weeks. These rates are bound to move somewhat higher in coming quarters, although Fed resolve to contain inflation pressures should put a lid on long rate movements.

The recent increases in long-term rates have essentially brought them back up to levels that prevailed when the Fed embarked on the series of short-term rate increases at the middle of last year. Thus, the yield curve has flattened by about 3 percentage points since then, leaving a 60 basis point spread between the 3-month and 10-year Treasury yields and an 80 basis point spread between the 3-month and 30-year yields. These are historically narrow term spreads, but a yield curve inversion does not seem to be a serious threat — at least in our forecast! [return to top]

Housing market indicators are throwing off mixed signals and a “cooling” process may be underway…

Recent data, on balance, have been suggesting that the housing market may be plateauing in terms of the volume of sales and starts. Furthermore, surveys of builders and mortgage lenders suggest that there is a flattening process going on out there.

Going forward, our forecast recognizes emerging affordability issues that have been created, first of all, by the succession of rapid house price gains in many parts of the country; indeed, we are seeing that affordability factor putting a bind on home buying now. And we expect the affordability issue to be more complicated as we go ahead, as the interest rate structure gravitates up further.

We’re also looking for less support to the housing market from two special factors that probably are temporary. One is heavy use of what Chairman Greenspan has called “exotic” forms of adjustable-rate mortgages, including deeply discounted interest-only adjustable-rate loans and payment-option loan structures. The financial regulators and rating agencies have been highlighting the risks to borrowers and mortgage investors, and the importance of these types of loans in the market should recede as time passes.

The other special factor has been a heavy presence of investors/speculators in hot housing markets. As housing demand fades (because of the affordability issues) and price appreciation slows, a lot of speculators should go to the sidelines. [return to top]

Housing markets should converge toward healthy and sustainable trend performances…

The housing sector has provided an unprecedented degree of support to the U.S. economy during recent years, but that support is bound to weaken. The good news: the housing slowdown should constitute an orderly adjustment toward sustainability, not the beginnings of a wrenching cyclical contraction.

NAHB’s forecast depicts an orderly slowdown in home sales and housing production in 2006 and 2007, combined with deceleration of national house price appreciation toward historic norms (around 5%). The production level we’re forecasting for 2007 is at the midpoint of the long-term forecast range we’ve established for this decade -- an average of 2 million new housing units per year (including manufactured home shipments). That range is based on estimates of demographics, net replacements and vacancies (including second homes) — the trend factors that eventually win out. [return to top]

Ben Bernanke will replace Alan Greenspan as Fed Chairman…

On Oct. 24, President Bush nominated Ben Bernanke to succeed Alan Greenspan as Federal Reserve Chairman. While he must still be confirmed by the Senate, in all likelihood Mr. Bernanke will be taking over the chairmanship after Greenspan’s term expires on Jan. 31, 2006 (the date of Greenspan’s last FOMC meeting). Bernanke currently is the chairman of the President’s Council of Economic Advisers, he previously served on the Federal Reserve Board (appointed to this position by President Bush in 2002), and he is a former chair of the highly regarded Princeton University Economics Department. In his most recent public appearance, Bernanke testified in Congress before the Joint Economic Committee on Oct. 20 (immediately before I testified to the same Committee). It appears that Bernanke’s views on the current housing market situation and the near-term outlook are remarkably similar to mine — including his perspectives on house prices.

Bernanke’s fundamental views on the appropriate long-term role of housing in the economy are not obvious at this point. Many macro economists tend to believe that housing receives policy preferences that could be directed elsewhere to the benefit of the overall economy — such as toward “productivity enhancing” capital investment. Whether Bernanke shares Greenspan’s deep-seated biases against policies that encourage the flow of capital into housing — including those related to Government Sponsored Enterprises and housing tax preferences — remains to be seen. [return to top]

The President’s tax-reform panel proposes measures that would put heavy hits on housing…

On Nov. 1, the President’s Advisory Panel on Federal Tax Reform submitted its report to the Secretary of the Treasury. That report, entitled “Simple, Fair and Pro-Growth; Proposals to Fix America’s Tax System,” assumes the Bush tax cuts of 2001 and 2003 are permanent (despite various expiration dates in current tax law), proposes immediate elimination of the Alternative Minimum Tax, proposes reductions in marginal tax rates (especially on savings), and proposes to broaden the tax base by scaling back or eliminating various tax deductions and preferences. The whole package is supposed to be “revenue neutral” as compared with current tax law (assuming permanence of the 2001/2003 Bush tax cuts).

The President instructed the Advisory Panel to maintain tax preferences for both homeownership and charitable giving, and the report complies with that mandate. However, the preferences for housing are both reduced and redistributed across income classes. Most important, the current deduction for home mortgage interest is replaced with a 15% tax credit against interest paid on smaller mortgage amounts (there are regional limits). Furthermore, the deductibility of property taxes is eliminated and the preferential treatment of capital gains on owner-occupied homes is made somewhat more restrictive. The low-income housing tax credit (for the production of affordable rental housing) also is eliminated in the Advisory Panel’s proposal.

Enactment of the Advisory Panel’s recommendations would raise housing costs sharply, particularly for homeowners in high tax brackets with large mortgages, a change that undoubtedly would put downward pressure on prices of relatively expensive homes and threaten the quality of mortgages on those homes. The huge gamble at the upper parts of the housing scale could be more than the Administration or Congress will be willing to take, and it’s probably impossible to design transition rules to avoid the negative price effects. [return to top]

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Eye on the Economy - 11/09/2005 (Plain Text Version)

The resilient U.S. economy will easily shake off shocks from the hurricanes…