| We continue to believe that the evolving economic expansion is in a self-sustaining mode that will systematically soak up a lot of the remaining slack in labor and capital markets over the next six quarters despite tighter monetary policy and fading fiscal stimulus. Indeed, we expect GDP growth in excess of 4% in the second half of this year, followed by 3.8% growth in 2005 (on a fourth-quarter to fourth-quarter basis). Chairman Greenspan reinforces messages delivered at the June 30 FOMC meeting … Federal Reserve Chairman Alan Greenspan presented the Fed’s semiannual Monetary Policy Report to the Congress on July 20-21. Greenspan reinforced the major messages contained in the June 30 Federal Open Market Committee (FOMC) statement (when the Fed implemented the first rate hike in more than four years). As a result, financial market reactions to Greenspan’s testimony were quite limited. Greenspan essentially brushed off the June “soft patch” in economic activity, focusing on trend growth in payroll employment and telling Congress that the softness in consumer spending should prove short-lived. He also stressed that the economic expansion was self-sustaining and had become more broad-based over time. With respect to core inflation, Greenspan reiterated the Fed’s belief that the recent acceleration had been boosted by transitory factors — including higher energy costs, past dollar depreciation, higher commodity prices and efforts by corporations to widen profit margins. But he did not say that core inflation was low, and he stressed the risk of higher inflation stemming from fundamental factors such as rising unit labor costs. All in all, Greenspan appeared more bullish on growth and slightly more hawkish on inflation than in other recent warnings, and he stressed that, “Inflation in the long run is a monetary phenomenon.” That’s a sharp reminder that containing inflation is the central bank’s job, and the Greenspan Fed is not about to shirk that responsibility. The FOMC’s forecasts suggest tolerance of strong growth but not accelerating inflation … As usual, the Fed’s semiannual Monetary Policy Report to the Congress contained projections of GDP growth, inflation and the unemployment rate by members of the FOMC (Fed Governors and Federal Reserve Bank Presidents). The “central tendencies” of these projections can be viewed as target or “tolerance” ranges for policymakers. If the ranges are breached, the FOMC could abandon the “measured” tightening process discussed in the June 30 FOMC statement and in Greenspan’s recent Congressional testimony. The FOMC’s projections show tolerance for highly aggressive GDP growth over the balance of 2004 and for continued above-trend growth in 2005. The projected ranges also show tolerance for systematic declines in the unemployment rate — to around 5% by late 2005. But the signals on acceptable inflation are much more restrictive. Indeed, the upper ends of the tolerance ranges for the core price index for personal consumption expenditures (the Fed’s favorite inflation gauge) were 2% for both 2004 and 2005 (fourth-quarter to fourth-quarter basis). This inflation gauge is already running close to that pace (1.6% in May), leaving little leeway for further acceleration as the expansion proceeds. In any case, we certainly know what to watch in assessing Fed policy prospects in the future — i.e., the monthly core personal consumption expenditures (PCE) price index. The ‘measured’ monetary policy tightening process still lacks definition … The June 30 FOMC statement said that “policy accommodation can be removed at a pace that is likely to be measured.” Greenspan’s Congressional testimony stuck with the “measured” tightening message but gave no new information on the prospective speed and extent of monetary tightening that’s on the Fed’s drawing broad. NAHB’s forecast still anticipates quarter-point rate increases at most of the FOMC meetings during the next six quarters (including the upcoming Aug. 10 meeting). We’re still expecting the target federal funds rate to be 2% at the end of 2004 and 4% by the end of 2005. If inflation is held below 2%, that tightening process will take the real funds rate a bit over 2% by late next year, and that should be close to the Fed’s view of monetary neutrality. If core PCE inflation rises above the Fed’s range of tolerance, of course, the funds rate will be raised even more aggressively. Long-term interest rates are holding as markets digest Fed messages and economic indicators … Bond market participants focus on long-term prospects for real economic growth, inflation and Fed policy. Long-term interest rates bounced up decisively from their March lows when a pickup in inflation became a clear reality and Fed statements abandoned the “patience” message used late last year. But long rates have been reasonably stable since late April, and the spread between the fixed-rate home mortgage and the 10-year Treasury bond yield has held steady at about 150 basis points. In his recent Congressional testimony, Greenspan recalled the destabilizing impact on long-term interest rates that occurred last summer when a shift in market expectations prompted holders of mortgage-backed securities to unload Treasuries as mortgage durations stretched out. Greenspan went out of his way to stress that the scope for such an upward push on long-term rates is quite limited this year, since the pace of mortgage refinancings is significantly down and markets have already adjusted to longer mortgage durations. Looking ahead, it’s reasonable to expect some increase in long-term rates as the Fed moves short-term rates upward, global economic growth moves ahead and inflation remains an issue. A key factor will be the correspondence between market expectations for growth, inflation and monetary policy and the unveiling of reality as time passes. But overall credit market conditions should tighten even if there is a close relationship between expectations and reality. NAHB’s forecast currently shows an increase of roughly 150 basis points in long rates between mid-2003 and the end of 2004, half the projected increase in the federal funds rate. Consumer attitudes strengthen as employment, income prospects improve and gasoline prices recede … The Conference Board’s index of consumer confidence showed a solid gain in July, rising by 3.2% to 106.1, and the University of Michigan’s measure of consumer sentiment apparently headed up as well (based on an early-month reading). That’s really good news, particularly in the wake of the surprising softening of retail sales in June. Both the current conditions and expectations components of consumer confidence posted gains in July, but the expectations measure accounted for the lion’s share of the overall advance. That’s good news since discretionary consumer outlays (including purchases of autos and homes) are more closely related to the expectations component. The improvements in consumer attitudes were fueled by lower gasoline prices as well as by improving conditions in the job market. The percentage of people reporting jobs as “plentiful” rose to the highest level since mid-2002 and the percentage expecting fewer jobs six months from now fell to the lowest in almost four years. A Conference Board economist noted that rising consumer confidence is very good news for President Bush. “When Bush’s father ran for re-election in 1992 his numbers were in the 50s. Anytime the numbers are over 100 it’s very good for an incumbent.” Home sales surge in anticipation of better economic times, higher interest rates down the line … The June “soft patch” in economic activity included a surprising falloff in housing starts as well as issuance of building permits. Indeed, single-family starts and permits fell by 9.5% and 6.2%, respectively, despite upbeat readings from NAHB’s monthly surveys of single-family builders and the Mortgage Bankers Association’s weekly surveys of home mortgage lenders. The June setback in starts and permits may have reflected caution by single-family builders about interest rate prospects down the line and the durability of sales contracts in a rising rate environment (i.e., cancellations could become a problem). But the setback may just have been a statistical anomaly, as surveys of both builders and lenders continued to throw off positive signals in July. One thing is for sure: the demand for homes is extremely strong. Sales of both new and existing homes easily hit records in the May-June period, and the June total came to an annual rate of nearly 8.3 million units — 15% above the record pace for 2003. This astounding performance has blown all known forecasts of home sales out of the water, and it is now clear that sales for 2004 will easily surpass last year’s records unless a real calamity occurs in the second half of this year. The explosion in sales of new homes naturally has drawn down unsold inventories, and the month’s supply stood at only 3.4 as of mid-2004. This lean position, combined with the positive signals from builders and lenders in July, bodes well for housing starts and permit issuance in coming months. NAHB’s forecast fully anticipates rebounds from the June numbers. Intense demand and limited supply provoke yet another surge in house prices … House prices have risen strongly in recent years despite the economic recession of 2001 and the threat of general price deflation last year. The recent surge in home sales, along with limited supply on the market, has caused yet another surge in house prices. The median price of existing homes sold in June was 10% above a year earlier, and all regions of the country showed strong gains. The median new-home price was nearly $210,000 in June — 12% above a year earlier. The recent price surge has resurrected charges of unsustainable price “bubbles” in the housing market. It’s certainly fair to say that recent rates of acceleration are unsustainable, and that price appreciation on the national level most likely will recede toward the growth rate in per-capita personal income (around 5% per year). But it’s also likely that prices will be stubbornly strong in areas beset by severe land shortages and stringent growth controls, including large parts of both coastal regions. | 
