| Core inflation is receding despite surging energy costs, and that’s good news for housing … Measures of core inflation (excluding prices of food and energy) moved up markedly during the early months of this year, on the heels of the deflation threat of late 2003. This quick transition changed the economic landscape quite a bit, prompting an upswing in long-term interest rates as well as renewed deterioration in the stock market. The inflation issue also kicked the Fed off the dime by June 30, and we’ve already seen a half-point increase in the federal funds rate target. While announcing the recent increases in short-term rates, the Fed suggested that some of the first-half upswing in inflation involved "transitory factors." Fortunately, recent price data support that view, with positive implications for long-term interest rates and possibly for Fed behavior down the line. Indeed, 10-year Treasury yields and long-term mortgage rates have declined by about 25 basis points since early August. On the data front, the core Consumer Price Index (CPI) advanced at an annual rate of only 1.2% in both June and July, following much larger increases during the January-May period. The July reading was up 1.8% on a year-over-year basis, still within the Fed’s 1-2% "tolerance zone" but definitely on the high side. However, an alternative "chain-core" CPI, allowing for floating rather than fixed weights (a better practice), showed only a 1.3% year-over-year increase in July. That presumably will broaden the Fed’s comfort zone to some degree. The Fed will continue the march back to monetary neutrality despite softer core inflation …
The increase in short-term rates at the Aug. 10 Federal Open Market Committee (FOMC) meeting simply brought the real (inflation adjusted) federal funds rate up to zero, and that’s much too "accommodative" for the Fed’s taste. The central bank clearly wants to work monetary policy back toward a neutral position as the economic expansion soaks up remaining slack in resource markets and ultimately threatens to generate a serious inflation problem. "Neutrality" probably involves a real federal funds rate around 2.25%, and that translates into a nominal rate of about 4.25% under most inflation projections. The Fed probably will strive to achieve monetary neutrality by 2006, at the latest, and the flow of economic information will affect the actual path of adjustment. Our current forecast pegs the federal funds rate at 2% by the end of 2004, 4% at the end of 2005, and 4.25% by mid-2006. But the timing of the adjustment could be affected by events outside the control of our policymakers, including shocks to world oil markets. Energy prices remain a wild card in the economic outlook …
Oil prices recently touched $50 per barrel, incorporating an estimated $15 premium for uncertainties related to the Middle East, Russia and Venezuela. Oil prices subsequently receded to some degree, but the fate of energy supply and price remains a major question mark in the economic outlook. The U.S. economy is much less vulnerable to oil price shocks than in the 1970s and early 1980s, but high energy costs still act like a tax on consumers and most businesses. We currently assume that the price for crude oil (West Texas Intermediate) will recede to about $35 per barrel by the end of this year and to around $30 by the end of 2005. But nobody really knows! Fortunately, the Fed can (and will) act to offset negative economic effects of higher energy costs with easier monetary policy. Thus, the path to monetary neutrality could turn out to be a rather tortuous trek. The housing market still is performing well despite some mixed signals in July … The single-family housing market has been the brightest star in the economic skies for several years. Both home sales and single-family housing starts soared to new records in the second quarter, house prices continued to move up aggressively and the nation’s homeownership rate soared to a new record (69.2%) in the process. Single-family housing starts and permits were quite strong in July, as both exceeded their record second-quarter averages. But July sales of existing homes (based on closings) were a bit off their second-quarter pace, and new-home sales (based on contract signings) receded by more than 7%. This setback in sales, combined with the robust starts/permits numbers for July, resulted in a significant increase in the number of new homes for sale as well as in the month’s supply (inventory/sales ratio). The unsold inventory issue actually doesn’t amount to much at this time since most of the increase in unsold units reflected units that were permitted but not yet started. The real issue relates to the strength of final demand for homes now and in the future. Some cooling of home sales from the robust second-quarter pace was virtually inevitable. That surge clearly was fueled by a lot of "fence sitters" who jumped into the market after mortgage rates hit bottom in March and speculation about rising rates was rampant in the financial markets as well as in the real estate community. This process pulled demand ahead and requires some payback in subsequent months. Surveys of both single-family builders (NAHB) and home mortgage lenders (Mortgage Bankers Association) suggest that home sales were well maintained in August, supported by the retreat of mortgage rates from the second-quarter bounce. Thus, it’s reasonable to expect housing starts to be well maintained in coming months, and housing should continue to provide firm support to the economy as the November elections come into focus. The economy promises to be a positive for President Bush, and housing is playing a key role … Prominent models that attempt to estimate the impact of economic performance on the outcome of presidential elections in the U.S. show strong positives for President Bush this November (economic projections in the models are similar to NAHB’s). Indeed, a model developed by Macroeconomic Advisers, LLC (MA) predicts that Bush will capture 60% of the popular vote. The MA model has correctly predicted the outcome of every presidential election since 1952. The MA model gives some edge to President Bush simply because he is an incumbent (1.9% of the popular vote). With respect to economic variables, Bush gets strong support from low inflation but he is docked for slow growth in real disposable personal income. Bush gets very strong support (1.8 percentage points) from a strong pace of housing starts projected for the election quarter. In the MA model, housing starts turn out to be a good summary measure of how voters view the economy — much better than measures of consumer confidence. According to MA analysts: "In contrast to confidence measures which are based on surveys, housing starts are hard economic data that reflect significant economic decisions of home builders and home buyers based on their sense of well being and confidence in the future." It’s important to note, of course, that models grounded on economic factors know nothing about things like the U.S. involvement in Iraq or domestic terrorism. But history shows that the overall economy and the housing market are powerful determinants in U.S. presidential elections. | 
