Second quarter growth will probably be revised up to 3% or so on August 30 from the originally reported 2.5%, a solid result given the 5.6% annualized jump in the first quarter. July and August data are pointing to an acceleration from the second quarter. Assuming 3% growth in the second quarter, 3.4% in the third and 3.3% in the fourth, the growth trend remains solid despite the long-awaited housing slowdown.
The Fed is probably using an output-gap theory to connect 2006 growth to the 2007 inflation rate. The idea is that inflation should slow if GDP is below its potential. The July benchmark revisions lowered the average growth rate and presumably the Fed’s assessment of the economy’s potential, especially given the declining trend the unemployment (under this theory, that’s an indication that growth was running above potential). A growth rate above 3% in coming quarters would probably raise a question-mark at the Fed about its 2007 inflation assumption.
There is general agreement that the housing market is likely to weaken further. The housing slowdown makes sense given the major run-up in prices and transactions and the rise in interest rates. However, other areas of the economy are showing enough strength to offset the housing slowdown – continued growth in consumption (July data due August 31), business equipment orders (17.5% annualized three-month growth through July), non-residential construction, and industrial production.
Precursors to a general slowdown?
Real interest rates are more consistent with an expansion than a slowdown. The August pause in Fed hikes caused a nearly 25 basis point drop in interest rates for two year and longer maturities, adding further monetary stimulus. Apart from the credit-control induced recession of 1980 (with inflation at 13%), there has never been a recession or substantial slowdown that wasn’t preceded by higher real interest rates than today’s spread. Profit growth remains strong through the first quarter, which normally means solid growth for at least a year. Second quarter data is due August 30, with profit growth expected to continue, a strong argument against a near-term slowdown.
The inventory-to-sales ratio is at near-record lows. This argues against the type of economic slowdown in which high real interest rates cause an inventory build and then an economic correction.
Initial unemployment claims are at a low 313,000, consistent with the 1990s labor boom (which supported much higher real interest rates.) In contrast, claims in March 2001 at the start of the recession were around 380,000 and climbing; in July 1990 at the start of that recession claims were around 360,000 despite a much smaller labor force, and were headed toward 509,000 by March 1991.
Housing weakness will not affect consumer resiliance
The prevailing view is that housing market weakness will soon slow consumption, taking pressure off other resources. This will allow the inflation rate to settle down in 2007, and justify the rate cuts priced into the bond market. Expect housing to weaken further but not to have a pronounced impact on consumption or GDP growth.
The economy has proved flexible in past transitions. It adjusted to Katrina, the California energy crisis, September 11 (the recession ended in November 2001), and the tripling of oil prices. A housing slowdown is part of a transition to a more balanced economy.
Non-residential construction, at 2.3% of GDP ( which is its lowest share ever), is in a position to offset much of the housing slowdown. If residential and non-residential investment return to their 1990s average share of GDP, it would have little net impact on GDP growth. Housing would lose 0.9% of its share of GDP, returning to 4.4%, while non-residential construction would gain 0.9% in its share, returning to 3.2% of GDP. This would still leave the combined construction rate well below its share in the 1960s-1980s. Most analysts are not forecasting this degree of adjustment in the economy, but there is a likelihood of a shift in this direction.
Expect consumer resilience despite the housing weakness, especially with regard to the unemployment rate, the growth in hours worked and wages, consumer confidence in the future job environment, and, to a lesser degree, the big gains in the U.S. household balance sheet (world’s biggest net creditor.)
Though the growth in household net worth has slowed with house prices and the stock market, gains in the last three years have pushed financial net worth (excludes houses) up $7 trillion and total net worth (includes houses) up $14.5 trillion. Gains in the median price of an existing home have slowed sharply since the middle of 2005. Even so, the median price rose to a new record ($230,000) in July. The median price of a new home was also $230,000 in July, down from the all-time record of $257,000 set in April, in part reflecting a slowdown in the sale of high-priced homes.
The connection between housing and the consumer is as deeply assumed as the 2005 forecasts of consumer slumps due to gasoline prices, rate hikes and the negative saving rate, the 2004 weak-job-growth worries, and the 2003 slump forecasts over the end of tax rebates. In each case, the consumer proved resilient, which is our expectation as housing slows further.