Eye on the Economy - May 9, 2005
By David F. Seiders, NAHB Chief Economist The economic ‘soft spot’ is confirmed by the first-quarter GDP report … Monthly data for March on payroll employment, foreign trade, retail trade and housing starts suggested that economic growth lost momentum toward the end of the first quarter, and the first-quarter report on Gross Domestic Product (GDP), released April 28, confirmed the existence of a “soft spot” in the economic expansion. Growth of real GDP receded to an annualized rate of 3.1% in the first quarter, down from 3.8% in the final quarter of 2004 and well below consensus expectations. Furthermore, a large buildup of business inventories contributed 1.2 percentage points to the overall GDP growth rate while final sales of domestic product grew at a tepid 1.9% pace. This kind of spending pattern hardly signals robust economic activity, leaving legitimate concern about economic momentum heading into the second quarter of the year. Forward-looking indicators suggest the second-quarter started out rather slowly … A number of forward-looking economic indicators suggest that the loss of economic momentum extended into the second quarter of 2005. The index of Leading Economic Indicators fell significantly in March, factory orders were disappointing that month as well following sizeable slippage in February, and measures of both Consumer Confidence (Conference Board series) and Consumer Sentiment (University of Michigan) lost ground in April after declines in March. The Institute for Supply Management’s assessments of conditions in the manufacturing sector also continued to slide in April. The weight of evidence now points toward GDP growth of about 3% in the second quarter, and that’s probably not enough to generate above-trend improvement in the labor market (depending on growth of labor productivity). To the extent that the first-half slowdown in economic growth is related to recent record levels of oil and gasoline prices, a fall in global oil prices should help strengthen growth in the second half of the year and in 2006. That’s our current hope and expectation. Core inflation continues to firm up, raising the ‘stagflation’ threat … Key measures of core inflation (excluding prices of food and energy) have been firming up for some time, and recent readings suggest that the process continues despite the soft spot in economic activity. The core components of the Producer Price Index and the Consumer Price Index posted year-over-year gains in March of 2.6% and 2.3%, respectively, and the annualized gains for the first quarter were higher than that. The Fed’s favorite inflation gauge — the core price index for Personal Consumption Expenditures — showed a year-over-year gain of 1.6% in the first-quarter GDP accounts and the March reading was up by 1.7%. Indeed, the annualized gain for March came to 3.2%, well above the Fed’s apparent comfort zone. The soft spot in economic activity, along with ongoing upward pressures on core inflation, smacks of “stagflation” — a demoralizing economic condition that’s inevitably exacerbated by anti-inflationary monetary policy. But it’s much too early to accuse the U.S. economy of slipping into such a state, and our forecast through 2006 continues to show a pattern of healthy economic growth and low inflation with modest upward pressures on interest rates. The Fed hikes short-term rates again despite slower economic growth and job creation … The Fed hiked short-term rates by another quarter point at the May 3 meeting of the Federal Open Market Committee (FOMC), raising the federal funds rate target to 3%. This automatically took the bank prime rate up to 6%. The quarter-point rate hike was widely anticipated, and the Fed’s assessment of the recent economic situation and the near-term outlook contained few surprises. The FOMC statement conceded that “the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices,” and that labor market conditions “apparently continue to improve gradually.” Despite this explicit recognition of the current soft spot in economic activity, the FOMC once again stressed that “pressures on inflation have picked up in recent months and pricing power is more evident.” That’s obviously the rationale for the upward rate adjustment implemented on May 3. The Fed is bound and determined to keep tightening at a ‘measured’ pace … The FOMC statement of May 3 said that monetary policy remains “accommodative,” even after the rate adjustment that day. The FOMC also continued to say that remaining policy accommodation can be removed “at a pace that is likely to be measured.” With respect to the balance of risks to the economy, the FOMC once again said that the upside and downside risks to the attainment of sustainable growth and price stability should be kept roughly equal “with appropriate monetary policy action.” This statement can be viewed as being true by definition, and it actually tells us very little. It seems clear that the Fed currently is placing a higher priority on fighting inflation than on stimulating real economic growth. Furthermore, the FOMC no longer says that core consumer prices are insulated from energy prices. Thus, further interest rate increases definitely are in store unless the economy falters badly. NAHB’s forecast still anticipates another quarter-point rate hike at the June 30 FOMC meeting and a funds rate target of 4% by year-end. Long-term rates remain stubbornly low despite rising shorts and percolating inflation issues … The apparent disconnect between short- and long-term interest rates has persisted despite efforts by the Federal Reserve to “talk up” long-term yields. Thus, the global “conundrum” that Chairman Alan Greenspan described on Capitol Hill in mid-February still is present in the financial markets. Indeed, the 10-year Treasury yield still is below 4.2%, even after yesterday’s hike in short rates by the Fed. It’s obviously hard to forecast long-term interest rates, but it’s hard to believe that long rates will stay this low if the Fed proceeds along the monetary policy path we’re projecting. That outcome would produce a virtually flat yield curve, and that’s often been a major economic complication. NAHB’s forecast currently shows a 10-year Treasury yield that’s close to 5% by year-end, implying a fixed-rate home mortgage yield near 6.5% ― up from about 5.8% at the end of April. We may not reach those levels, but rate pressures most likely will be upward as 2005 rolls along. The housing sector powers through the economic ‘soft spot’ … Home sales and housing starts were quite good in January and February, but housing starts fell sharply in March — contributing to the economic soft spot and raising serious questions about the sustainability of the dramatic housing expansion. However, the weight of evidence now clearly shows that the housing expansion is intact. Issuance of building permits held up reasonably well in March (off by 4%), and some special factors apparently held down both starts and permits for the month. NAHB’s Housing Market Index (based on surveys of single-family builders) was reasonably stable and at historically high levels in both March and April, suggesting that builders still saw strong demand on the part of current and prospective home buyers. The strength of housing demand has been confirmed by robust sales of both new and existing homes in March as well as by robust levels of applications for mortgages to buy homes through the month of April. Indeed, sales of new homes soared to a record high in March, and the first quarter of 2005 also stands at an all-time high. The housing outlook remains quite positive … The great strength of the first quarter, and the surprisingly low levels of long-term interest rates since then, have provoked upward revisions to NAHB’s forecasts for home sales and housing starts in 2005. We’re now looking for declines of less than 2% for the year as a whole, and it’s entirely possible that 2005 will equal or surpass the records of 2004. | 
