| The Federal Reserve presumably has a target range for core inflation, and Fed statements suggest an acceptable upward bound of about 2%. Some key inflation measures obviously are approaching that level rather quickly, a fact that has not been lost on the financial markets. Financial markets struggle to digest new domestic economic realities, unsettling global issues … The impressive pickup in job growth and upswing in core inflation definitely caught the markets off guard. Recognition of the new economic realities, and the prospects for earlier-than-expected rate hikes by the Federal Reserve, provoked selloffs in both the stock and bond markets beginning in the latter part of March. Indeed, major stock indexes recently hit their lows for the year and long-term interest rates climbed by about a percentage point in the process. Soaring prices on global oil markets, record gasoline costs here at home and a drumbeat of unsettling news from Iraq and other parts of the Middle East have compounded concerns and confusion in financial markets. It’s hard to sort out the relative importance of the various factors that have been buffeting the markets, but the dominant concern appears to be the course of core inflation and mounting pressures on the Fed to start hiking short-term rates. The Fed is being pushed to raise short-term rates by mid-year … At the conclusion of the May 4 Federal Open Market Committee (FOMC) meeting, the Fed stated that the current extraordinary degree of monetary policy accommodation (a federal funds rate of 1%) “can be removed at a pace that is likely to be measured.” Events in the economy and the financial markets since then are pushing the Fed to begin the rate increases sooner rather than later. There’s now a very high probability of a quarter-point increase in the federal funds rate target at the next FOMC meeting on June 30, and that presumption is now incorporated in NAHB’s forecast. We’re also assuming quarter-point increases at the Aug. 10 and Nov. 10 meetings, bringing the funds rate up to 1.75% for the balance of the year. The Fed presumably is planning to move the federal funds rate to a “neutral” position that neither stimulates nor impedes growth of the economy. Neutrality is around 4% on a nominal basis and 2% in real (inflation-adjusted) terms. We currently assume that the Fed’s march to neutrality will take about two years, but the speed of adjustment will be heavily influenced by the actual path of core inflation. We believe that the recent acceleration of core CPI inflation contains some temporary elements, and that downward pressures on unit labor costs will help contain core inflation going ahead. If these judgments prove to be wrong, the Fed will move toward neutrality even more quickly. President Bush finally nominates Alan Greenspan for another term as Fed chairman … Alan Greenspan’s term as chairman of the Federal Reserve Board expires on June 20. About a year ago, President Bush expressed interest in appointing Greenspan for another term, a concept that Greenspan embraced at that time. But lack of concrete action on this front began to create suspicion in financial markets that the President was holding up the appointment in an attempt to influence Fed policy in an election year. This issue was swept aside on May 18 when Bush announced his nomination of Greenspan for a fifth term as Fed chairman, a nomination the Senate is sure to approve and an appointment Greenspan is sure to accept. Settling this issue appeared to have a calming effect on the markets. Greenspan’s new term as Fed chairman will run to mid-2008, but his term as a Federal Reserve Governor runs only until early 2006. It’s a good bet that Greenspan will be turning over the reins at that time, and hopefully the economy will then be cruising on trend with monetary policy in neutral. That certainly would add to the impressive Greenspan legacy. The housing sector stands tall amidst shifting economic and financial market conditions … Rising interest rates typically mean trouble for the housing sector, and the prospect of systematic monetary tightening by the Fed typically has been a prescription for disaster. But housing has been unscathed so far, and the outlook remains quite positive despite the obvious direction of future Fed policy. Available housing data for April and May are quite reassuring, in the face of the substantial runup in long-term interest rates since late March. Housing starts were off only marginally in April following a weather-boosted surge in March, and the April performance actually exceeded the first-quarter average. Issuance of building permits rose slightly in April, easily surpassing the first-quarter average, and a substantial backlog of unused permits at month-end bodes well for starts activity in coming months. NAHB’s Housing Market Index, based on surveys of single-family builders, held at a robust level (69) in May as builders’ assessments of buyer traffic as well as current and expected home sales were quite positive. Furthermore, weekly surveys of lenders (conducted by the Mortgage Bankers Association) show robust applications for mortgages to buy homes through mid-May. It appears that the recent interest rate increases actually have stimulated (rather than impeded) home buyer demand. And the housing outlook remains bright … Looking ahead, we continue to believe that housing market activity will be very well maintained over the balance of this year and in 2005, despite the projected rate hikes by the Fed and some further increases in long-term rates. We’re counting on the economic expansion to generate solid job growth as well as stronger growth of personal income, factors that should largely offset the drag from higher rates. Indeed, we now project that home sales and housing starts for 2004 will narrowly exceed the excellent performances of 2003, and that 2005 will be off by only about 5% from this year. | 
