Inflation Uncomfortably High, but Relief Underway

MBA (8/25/2008 ) Velz, Orawin
The large swing in total housing starts from a 10.4 percent increase in June to an 11.0 percent drop in July reflected the impact of a building code change for multifamily units in New York. Excluding the volatile multifamily starts, single-family starts showed a clear trend of the housing market as single-family homebuilding continued its 14th monthly decline in the last 15 months.
Despite the steady drop in the number of new homes available for sale for more than a year, the months’ supply (inventory-sales ratio) for new homes remained as high as 10 months in June, as housing demand has pulled back along with the declining housing supply.

Home builders saw some improvement in sales prospects over the next six months as they anticipated that a temporary $7,500 tax credit will give enough incentives for some potential first-time home buyers to get into the market. However, the overall confidence level of builders remained depressed at a record low in August, according to the National Association of Home Builders/Wells Fargo Housing Market Index.

With no signs of a turnaround in the housing market in the near term, housing will likely remain a drag on economic growth through next year. One report last week indicated that the acceleration in economic growth in the second quarter, induced by the fiscal stimulus and trade, was not sustainable. The Conference Board’s Index of Leading Indicators—a gauge of future business activity three to six months ahead—fell sharply in July, reinforcing the view that the U.S. economy is poised for a slowdown in the second half of this year along with most European countries and Japan.

The 1.2 percent jump in the July Producer Price Index disappointed those looking for signs of an ease in inflation as domestic and global growth slows. In his speech at the annual Federal Reserve conference in Jackson Hole, Wyo., Fed Chairman Ben Bernanke said the rebound in dollar and declines in commodity prices should help moderate inflation but warned that if inflation failed to slow over the “medium term,” the Fed will be ready to act as necessary to keep inflation under control.

While further declines in crude oil and commodity prices should help moderate the overall PPI in the near term, the 0.7 percent jump in the core PPI raised the question of whether core prices will decelerate with the overall prices in the coming months. However, with incoming data showing more evidence of a slowdown in economic activity and renewed concerns regarding the mortgage market, raising the risk of spillover effect to the overall economy, the Fed will likely hold interest rates steady for the rest of the year.

In his Jackson Hole speech, Bernanke observed that financial turmoil has not yet subsided, and is contributing to slower growth and higher unemployment. The odds that the Fed will raise the target rate by 25 basis points by the end of the year were 25 percent on Friday, according to fed funds futures.

Long-term Treasury yields remained low last week as financials continued to weigh down stocks, increasing demand for Treasuries. The yield on the 10-year Treasury note stayed below 3.90 percent through Friday. Mortgage rates also declined last week but to a lesser extent than the drop in the benchmark 10-year yield. The spread between the yields on 10-year Treasury notes and conforming fixed-rate mortgages widened further to about 265 basis points this week, the widest spread since mid-March.

Housing and Mortgage Indicators:
The National Association of Home Builders/Wells Fargo Housing Market Index held steady at 16 in August, matching the record low reached in July. (Readings below 50 indicates that more respondents view conditions as poor.)

The survey asks builders for their sentiments on current sales, traffic of potential buyers, and projected sales over the next six months. While the overall index held steady, two out of three of the component indices rose during the month. The index gauging current sales conditions increased to 16 from a record low reading of 15 in July, while the index gauging sales expectations for the next six months increased slightly to 25 from 23.

The NAHB attributed the increase in the latter to builders’ anticipation that a temporary $7,500 tax credit will give enough incentives for reluctant potential first-time homebuyers to get into the market. The index gauging traffic of prospective buyers remained unchanged at the record low of 12.

Regional performance varied. Two regions experienced increases: the Northeast saw a two-point increase to 16, and the Midwest posted a four-point decline to 14. The South’s index was unchanged at 20 while the West posted a three-point drop to 11. In addition to large inventory overhang and tighter lending standards, rising foreclosure rates, which led to deep discount prices in the existing home market, have hurt the new home market, especially in the West.

The Housing Market Index is considered one of the leading indicators of future home sales because it also captures sales expectations over the next six months. Given little improvement in the index, new home sales will likely remain sluggish in the coming months.

Total housing starts fell 11.0 percent in July to a seasonally adjusted annualized rate of 965,000. Single-family starts dropped 2.9 percent, reaching the lowest level since January 1991. Multifamily starts were down 30.4 percent as they plummeted in the Northeast, reversing some of the prior month’s surge (which was the result of a rush to start building activity before local building code changes took effect in New York).

Total starts decreased 30.4 percent in the Northeast following a 103.2 percent jump in June. For the region, multifamily starts fell 44.1 percent, only partially offsetting the 229.8 percent surge in June. Starts dropped in the South and the West by 10.5 percent in each region and rose 10.0 percent in the Midwest.

Through the first seven months of this year, single-family starts were 40.2 percent lower than those in the first seven months of 2007. By contrast, year-to-date multifamily starts with 5 units and over were 19.4 percent higher than those last year. Year-to-date construction of structures with 2-4 units declined 41.4 percent.

Total permits fell 17.7 percent in July, driven by a 63.4 percent drop in permits in the Northeast as multifamily permits sharply fell. Single-family permits—a leading indicator for single-family housing activity—dropped 5.2 percent, the biggest decline since January. This marked the 15th decline over the past 16 months. Single-family permits fell in every region but the Northeast.

Economic Indicators:
The Producer Price Index rose 1.2 percent, following a 1.8 percent increase in June and 1.4 percent rise in May. Large increases in energy prices, including electricity, heating oil and natural gas, led the overall increase. Over the past year, the PPI rose 9.8 percent, the largest gain since June 1981.

Excluding food and energy items, the core PPI was up a strong 0.7 percent following a modest 0.2 percent increase in both June and May. Higher prices for cars and light trucks as well as for capital equipment led the increase in the core producer prices. From a year ago, the core PPI rose 3.6 percent, the largest gain since May 1991.

The Conference Board Index of Leading Indicators fell 0.7 percent in July, following an unchanged reading in June. The drop puts the index at its lowest level since October 2004. A sharp decline in residential building permits, which was a payback for a change in building codes that lifted multifamily starts in June, led the decline in the index. Other negative contributors included declining stock prices, higher unemployment claims, and a drop in the money supply.

The Conference Board’s index of leading indicators is designed to forecast economic activity and turning points in the business cycle based on 10 economic components. Weakened readings in the index in the past several months point to "slow growth the rest of the year, and possibly an economy grinding to a halt," according to The Conference Board.