Inflation Pressures Are Easing but Rate Cut Forecast Remains Uncertain

The New Year is beginning where the old one ended -- with uncertainty about when – or whether – the Federal Reserve will begin cutting interest rates.

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The June employment report had a Goldilocks element – strong, but not too strong― perhaps not “just right,” but strong enough to suggest continued improvement in the labor market without pressuring the Federal Reserve to accelerate the phase-out of its bond-buying economic stimulus program.

The 195,000 jobs employers created didn’t pop champagne corks, but the total did beat estimates, providing evidence that the economy is fending off the continued negative effects of rising payroll taxes that are curbing consumer income and government cutbacks that are slashing public-sector payrolls.

The unemployment rate for the month remained unchanged at 7.6 percent and the job reports for April and May were both revised upward, producing what analysts termed a generally “positive” report. Inc. said in a statement.

Cautionary Signs

Media reports focused on those positives, but anyone looking for cautionary signs could find them in the Household Survey on which the unemployment rate is based. Although the number of people entering the job market exceeded the number leaving it, the underemployment rate (including part-time workers who want full-time jobs and discouraged workers who have given up hope of finding employment )– increased to 14.3 percent, a four-month high, suggesting that employment growth remains sufficiently short of warp speed to allay concerns that the Fed will act prematurely to “taper” the $85 billion per month bond purchase program credited with bolstering the economy and underpinning the housing market’s recovery.

Fed officials have been struggling to allay those fears ever since Fed Chairman Ben Bernanke indicated in June that the Fed could begin phasing out its bond-buying activities by the end of next year. His remarks sent interest rates up and the stock market down – leading Bernanke to “clarify” that a change in the Fed’s policy is not imminent and will be gradual when it comes.

“Our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook,” Bernanke told reporters during a press conference.

Mixed Reports

Other economic indicators for the month were mainly, but not entirely, positive.

  • The first quarter growth rate, estimated initially at 2.4 percent, was revised to 1.8 percent, slowing from a stronger 2.5 percent growth rate in the fourth quarter of last year.
  • The Institute for Supply Management’s (ISM’s) manufacturing index moved back into solidly positive territory, rising to 50.9 in June after slipping below the 50 mark separating growth from contraction the previous month. But the ISM’s services index declined to 52.2, reaching its lowest level in more than three years.
  • Consumer confidence, on the other hand, reached its highest level in more than 5 years in June, jumping from 74.3 in May to 81.4 in the Conference Board index. Consumers’ views of current conditions and their outlook for the next 6 months both improved. The index remains below the 90 reading indicating a healthy economy, but the recent gains suggest that consumer spending is likely to remain strong enough to keep the economic recovery on track. “The pace of growth is unlikely to slow in the short-term and may even pick up moderately,” Lynn Franco, director of economic indicators at the Conference Board, said in a press statement.

Housing Confidence

Consumer confidence is driving the housing market recovery, which continues to gain traction. Existing home sales reached their highest pace in 6 years in May, increasing 4.2 percent over April and beating the year-ago rate by nearly 13 percent, according to the National Associations of Realtors (NAR). This was the largest year-over-year increase recorded since October 2011, when a limited-time federal tax credit goosed home buying activity.

In other signs of strength, the time on market is falling (nearly half the homes sold in May were listed for less than a month), prices are rising (more about that later) and listing inventories, which have been tight for months, are increasing as sellers begin to respond to positive reports about increasing buyer demand and rising prices. The inventory level stood at 5.1 months in May, less than half the year-ago mark. The NAR’s pending sales index, meanwhile, increased by 6.7 percent to 112.3 in May, its highest level in 7 years.

Rising interest rates which could crimp affordability and curtail sales at some point, appear to be having the opposite effect in the near-term, pushing heretofore hesitant buyers off the fence and into the housing market.

New Homes Rising

New home sales are clearly benefiting from that trend, posting their third consecutive monthly increase and reaching a five-year high in May. Industry executives applauded the continuing evidence of recovery in an industry that had been battered by the downturn, but cautioned that tight credit, shortages of buildable lots and labor and rising materials costs could cloud the outlook.

New home starts increased by 6.8 percent in May, but most of the increase was in the multi-family sector; single-family starts were essentially flat, compared with April. However, permits for future construction skewed strongly toward the single-family side, edging up 1.3 percent to an annualized permit rate of 622,000 units, the highest in 5 years.

Builder confidence levels, measured by a National Association of Home Builders (NAHB) index reached a 7-year high, surging 8 points in June to 52 – the first above-50 reading for this barometer since 2006. Reflecting that confidence, and possibly stimulating it, more than 35 percent of the new home sales recorded in May were for homes under contract but not yet under construction, according to a Commerce Department report.

“There [are] clearly more housing starts activity in the pipeline,” Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC, told Bloomberg News. “The economic outlook is getting better and…the household formation [rate is increasing],” he added. “With demand rising, production is going to follow.”

Price Records

Home price trends support that optimistic projection. The S&P Case-Shiller 10- and 20-city price indexes posted their highest monthly gains ever (2.6 percent and 2.5 percent, respectively) in May, while reporting double-digit (11.6 percent and 12.6 percent) gains for the year. Separately, Homes.com reports that prices in 14 major markets have passed their pre-decline peaks and Lender Processing Services reports that prices nationally have regained nearly half the value they have lost since the market began to disintegrate in 2006.

Rising prices have sparked fears of another price bubble, but most analysts are downplaying those concerns. “The rise in prices is a signal to the market to supply more housing. This is exactly what we expect to happen over the next several years,” analysts at TD Economics wrote in a recent research note. In addition to stimulating new home construction, rising prices will lead more owners to sell their homes, increasing inventories and reducing upward pressure on prices, these analysts and others predict.

A similarly benign view of rising interest rates also prevails, at least for now. “Home buyers have survived rising mortgage rates in the past, often by shifting from fixed rate to adjustable rate loans, David Blitzer, chairman of the S&P Index Committee, noted in a press statement. In the housing boom, bust and recovery, banks’ credit quality standards were more important than the level of mortgage rates, he noted, and recent reports suggest that “some banks are easing credit restrictions. Given this, the recovery should continue,” Blitzer predicted.

Jonathan Smoke, chief economist at Hanley Wood, agrees. Concerns about rising interest rates squelching the housing recovery are way overblown,” he said in a recent commentary. “If anything, we think the rise in mortgage rates will encourage even more would be buyers to get off the sidelines before both prices and interest rates are much higher. And that scenario—a market where we all expect prices to be higher in the future—bodes for the future…”