| Payroll employment growth was disappointing in September but the job market still is improving … Above-trend rates of GDP growth have been generating improvements in the U.S. labor market since mid-2003, and that process is likely to continue in coming quarters. The average pace of improvement has been less than robust, however, and month-to-month changes in payroll employment have hardly been systematic. Indeed, the condition of the labor market remains a key issue in the presidential campaigns as the November election approaches. The employment report for September hardly clarified the labor market situation. The unemployment rate held at 5.4%, only a percentage point below the cyclical peak in June of last year. Furthermore, payroll employment increased by only 96,000 in September, and the private sector component grew by only 59,000 jobs. The length of the average workweek showed no gain at all, and the index of aggregate hours worked in the nonfarm business sector posted only a marginal gain. The Labor Department discussed likely adverse net impacts of the series of hurricanes on employment growth in September, but declined to give an estimate of the impact — saying only that “payroll employment continued to trend up in September.” Private sector estimates of the hurricane effect average about 50,000 jobs, and this adjustment would put September close to the average monthly gain for the year to date (about 175,000). NAHB’s forecast shows an ongoing uptrend in payroll employment and a further downward drift in the unemployment rate in coming quarters, despite good growth in labor productivity (output per hour). But there will be no more employment reports before the elections. Core inflation firmed up in September, moving toward the upper end of the Fed’s tolerance range … Core inflation (excluding food and energy) subsided during the June-August period from the accelerated month-to-month rates recorded earlier in the year, confirming the Federal Reserve’s judgment that “transitory factors” had affected those readings. But key measures of core inflation firmed back up in September, keeping inflationary pressures on the radar screens of both the central bank and the financial markets. The first alert was sent by the core Producer Price Index (PPI) for September. This measure posted a year-over-year advance of 1.9%, up from 1.5% in August and less than 1.0% late last year. The second alarm was sent by the core Consumer Price Index (CPI), which posted a 2% year-over-year increase in September — the highest for the year. The chain-core CPI (incorporating floating weights) was up to 1.6%, the highest for this year and double the pace of late 2003. Recent core inflation rates certainly are not high by historical standards, but the Fed definitely will be on guard against further increases. Although the central bank has not precisely defined its tolerance range for inflation, the balance of public statements suggests the Fed will fight against core inflation (of the floating-weight variety) above 2%. Oil prices remain a key wild card in the economic outlook … High oil prices definitely pose a threat to the U.S. and global economic recoveries. Prices recently hit record levels ($55 per barrel for WTI light crude), demand is quite strong, hurricanes in the Gulf of Mexico have disrupted supply and major uncertainties surround the supply situation in other parts of the world. These uncertainties include the standoff between the huge Yukos company and the Russian government, rebel activity in Nigerian oil fields, strikes by Venezuelan oil workers, ongoing disruption of Iraqi oil supplies and the threat of terrorist attacks on key Saudi oil facilities. Higher prices of gasoline, heating oil and natural gas figure to take some toll on U.S. growth in the fourth quarter, partly through the export market, and NAHB’s baseline (most probable) forecast for GDP growth has been trimmed a bit as a result (to 3.6%). Our forecast assumes that oil prices will recede before long, averaging about $40 per barrel (WTI) in 2005. But it’s not hard to construct a crisis scenario where prices hang around recent records for an extended period. This scenario involves weaker U.S. and global growth as well as efforts by U.S. and foreign central banks to support economic activity (probability: 20%). The Fed is likely to increase short-term rates another notch before year-end, despite the oil price surge … At the conclusion of the Sept. 21 Federal Open Market Committee (FOMC) meeting, the Fed described the risks to both sustainable economic growth and price stability as “balanced,” characterized its monetary policy stance as “accommodative,” and said further rate increases would occur at a “measured” pace on the path back to monetary neutrality. The Fed presumably still adheres to the basic judgments expressed on Sept. 21, and NAHB’s forecast still shows one more quarter-point hike in the federal funds rate this year — specifically, at the Nov. 10 FOMC meeting. We assume the Fed will go ahead with this adjustment despite the prospects for a fourth-quarter slowdown in GDP growth, partly because of the recent firming up of core inflation. There’s been a good deal of speculation about possible influences of record-high oil prices on Fed management of monetary policy. Although the Fed undoubtedly will pursue a more stimulative policy path if oil prices truly threaten the economic expansion, Chairman Alan Greenspan recently went out of his way to say that situation is not imminent. Indeed, he downplayed the negative impacts oil prices are having on the economy, in absolute terms and in comparison with the oil price spikes of the 1970s. Greenspan also said that the recent runup in oil prices was “attributed largely to Hurricane Ivan” and that “part of the recent rise in spot prices is expected to wash out over the longer run.” Long-term rates remain quite favorable although upward pressures should be developing soon … Long-term interest rates have receded since mid-year despite the 75 basis point increase in short-term rates implemented by the Fed since June 30 and the high probability of further rate hikes before long. Indeed, the 10-year Treasury yield now is about 4%, compared with 4.7% on June 29. The bond markets apparently are shrugging off evidence of firming core inflation and are focusing largely on the prospects for slower economic growth as well as less aggressive increases in short-term rates by the Fed (compared with earlier expectations). NAHB’s baseline forecast suggests that this set of expectations is not likely to materialize and that long-term rates will begin to gravitate upward before long. We’re currently projecting a quarter-point increase in bond and mortgage rates by year-end and another percentage point rise during 2005. But, again, a lot depends on the course of oil prices. Slippage of housing starts in September does not signal fundamental weakness in the market … Housing starts fell by 6% in September, including an 8% reversal of single-family starts (multifamily moved up by nearly 5%). This decline prompted widespread discussion in the media about a fundamental downshift in the single-family market related to erosion of consumer confidence/sentiment in the August-September period as well as to anecdotal reports of consumer resistance to high house prices in some areas (such as Las Vegas and Southern California). Actually, the falloff in single-family starts was associated primarily with unusually wet weather in many parts of the country (including the entire East Coast). Issuance of building permits was up by 2% in September, and the backlog of unused permits moved up to an historically high level in the process. This pattern clearly shows the influence of weather conditions on starts in September and the large permit backlog bodes well for single-family starts in October. Furthermore, economic and financial market conditions certainly are supportive at this time, and NAHB’s Housing Market Index (based on monthly surveys of single-family builders) showed a solid increase in October. Greenspan downplays role of speculation in recent home price surge … House prices surged in the spring and summer as falling mortgage rates energized home buyer demand while builders faced severe land-use constraints in many parts of the country. Several major Wall Street media outlets (including Fortune and Barron’s) argue that speculators also have fueled the process, bidding up prices with the intention of “flipping” the properties in short order for quick gains. Greenspan addressed this issue during a speech given to a group of bankers on Oct. 19. He noted that large transactions costs are “significant impediments to speculative trading in homes” (compared with financial instruments or commodities) and an “important restraint on the development of price bubbles.” Greenspan also pointed out that speculation ordinarily does not involve owner-occupied residences — home owners must move and live elsewhere — and that participants in speculative trading most likely are investors in single-family rental and second-home properties. In this regard, he cited evidence that mortgage borrowing by such investors amounted to only about 10% of total home mortgage originations in 2003, up from other recent years but still not that big a deal. While conceding that local economies may experience significant speculative price imbalances, Greenspan stressed that “a national severe price distortion seems most unlikely” in the U.S. | 
