Overview: This week's economic reports continued a string of positive data, other than the housing sector. While revised gross domestic product showed that the economy barely grew in the first quarter of this year, more recent data indicate strong momentum entering the current quarter.
The economy created 153,000 jobs in May -- a strong pickup from April's 80,000 gain. Manufacturing activity also strengthened in May, according to the Institute for Supply Management (ISM) manufacturing survey. Nonresidential construction spending enjoyed a solid gain in April, more than offsetting continued weakness in residential construction spending. Despite rising gasoline prices, consumers appeared to be holding up well, with personal consumption spending increasing at a healthy pace in April. Both main measures of consumer confidence also advanced in May.
The inflation picture brightened as well. For the first time in 13 months, the Federal Reserve's measure of inflation -- the personal consumption expenditures (PCE) deflator excluding food and energy items -- decelerated to stand at the top of the Fed's comfort zone. The year-over-year increase in the core PCE was 2.0 percent in April. This provides supporting evidence that measures of core inflation have moderated. April's year-over-year gain in the core consumer price index (CPI) reported last month also slowed to 2.4 percent -- staying within the Fed's comfort zone of 1.5 to 2.5 percent for the core CPI measure.
The weak housing market will keep economic growth below average for the rest of the year, however. Job losses in housing-related industries have intensified over the past several months. Employment in the mortgage industry, which includes employees in nondepositary real estate credit intermediation and mortgage brokers, declined by 10,200 in April from March. (Data for detailed industries are released with a one-month lag.) The industry lost 30,400 jobs from April 2006.
Residential construction spending fell in April for the 12th time in the past 13 months. By every measure, house prices also weakened further this year. While most measures are showing a year-over-year decline for the nation's home prices, one measure -- the House Price Index from the Office of Federal Housing Enterprise Oversight (OFHEO) -- continues to show positive, albeit slower, gains of over 4 percent from a year ago. The OFHEO index, however, is based largely on conventional, conforming loans. The sample under-represents houses financed with FHA, jumbos, subprime and adjustable-rate mortgage loans -- which have shown relatively worse performance over the past year.
Housing and Mortgage Indicators:
Construction spending rose 0.1 percent in April -- the third consecutive month of increase. Private residential construction fell 1.0 percent. Private nonresidential construction increased a solid 1.5 percent. Public construction rose 0.7 percent, led by increases in spending on state and local projects.
The Case-Shiller house price indices showed that home price weakened in March. Like the OFHEO house price index, the indices track repeat sales of the same single-family house over time, and therefore they control for the mix of high- and low-price home sales.
From a year ago, the 10- and 20-metro area composite indices were down about 2 percent in March. Prices fell from a year ago in 13 out of 20 metro areas. The national index, which has a broader coverage (37 states) but is released only on a quarterly basis, was down 1.4 percent in the first quarter of this year from a year ago. This is the first year-over-year decline since the third quarter of 1991. Prices were up by a double-digit pace from a year ago as recently as the first quarter of 2006.
The Office of Federal Housing Enterprise Oversight (OFHEO) House Price Index rose 4.3 percent in the first quarter of this year from a year ago -- moderating from 6.1 percent in the fourth quarter of 2006. This is the slowest year-over-year pace of increase since the third quarter of 1997. The OFHEO index is based on data from sales and refinance transactions from Fannie Mae and Freddie Mac. Massachusetts and Michigan were the only two states that saw a decline in prices from a year earlier.
The index presents a more optimistic picture of the trend in house prices over the last year than other measures of existing home prices. For example, the National Association of Realtors median home prices and the Case-Shiller home price index both showed a year-over-year decline in the first quarter. Since the mix of sales can result in a bias in the median price measure, it is more appropriate to compare the OFHEO index with the Case-Shiller index. Both indices use the same methodology that controls for the mix of high- and low-priced home sales by tracking repeat sales of the same houses over time.
One reason that may explain better performance in the OFHEO index is that the index essentially includes only conventional, conforming loans and thus largely excludes high-priced homes such as those in California. OFHEO noted in yesterday's release that 22 of the 26 cities in California on its list experienced year-over-year price declines. OFHEO also released the purchase-only index, which excludes refinance transactions. The purchase-only index showed slower appreciation rates than the overall index -- a 3.0 percent increase from a year ago. On a state level basis, 23 states saw quarterly home price declines in the purchase-only index, compared with only 7 states for the overall index.
The Mortgage Bankers Association Weekly Survey of Mortgage Applications for the week ending May 25 showed that mortgage demand decreased, with the Market Index declining 7.3 percent to 636.4. The purchase Index decreased 2.5 percent, while the Refi Index fell 20.0 percent.
The 30-year fixed mortgage rate increased 9 basis points to 6.32 percent, while the 1-year adjustable rate increased 2 basis points to 5.74 percent. The spread between fixed and adjustable mortgage rates widened to 58 basis points. The ARM share of mortgage applications was 17.7 percent of the number and 29.4 percent of the dollar volume of new applications -- each about half a percentage point lower than the previous week.
Economic Indicators:
The preliminary estimate of gross domestic product (GDP) showed that real (inflation adjusted) GDP grew 0.6 percent in the first quarter of 2007 -- a downward revision from 1.3 percent reported earlier in the advance estimate. (Unless otherwise noted, data reported here are seasonally-adjusted annualized rates.)
The downward revision to growth was a result of three factors. A downward revision to inventory investment and an upward revision to imports reduced GDP. An upward revision to personal consumption expenditures partially offset the impact of the first two factors.
The housing market was the biggest drag to growth. Real residential investment declined 15.4 percent in the first quarter -- still smaller than the 19.8 percent drop in the fourth quarter. Over the past year, investment in residential structures has declined 16.5 percent -- the biggest year-over-year drop since the first quarter of 1991.
Payroll employment increased 157,000 in May, compared with a gain of 80,000 in April. The unemployment rate was unchanged at 4.5 percent. Construction, financial services, retail trade and manufacturing shed jobs, while service employment saw strong gains.
Average hourly earnings were up 0.3 percent in May and 3.8 percent from a year ago. The year-over-year increase eased from a peak rate of 4.3 percent reached last year.
The Institute for Supply Management (ISM) manufacturing index edged up to 55.0 in May from 54.7 in April. (A reading of 50 or above indicates an expansion in the manufacturing sector.) The ISM manufacturing index is based on a survey of purchasing executives at roughly 300 industrial companies. It includes nine different sub-indices: new orders, production, employment, supplier deliveries, inventories, prices, new export orders, imports and backlog of orders.
The overall index stood at its highest level since April 2006, suggesting that the manufacturing industry is gaining momentum in the second quarter. The details of the report point to continued improvement in manufacturing activity over the coming months. The new order index -- a forward-looking component of the index -- was at its highest level since February 2006.
For the third consecutive month, manufacturers reported that their customers' inventories were too low except in housing-related industries such as furniture & related products and fabricated metals. On net, the report indicates that businesses are successfully working off their excess inventories, which bodes well for future production.
Personal income fell 0.1 percent in April -- the first decline since August 2005 -- as a result of a drop in wage and salary income. The decline was due to a technical factor. The Bureau of Economic Analysis noted that it has added $50 billion (at an annual rate) to wage and salary income in each of the first 3 months of the year to account for unusually large bonus payments and the exercise of stock options. This is an initial estimate as actual data are not available at this time. The BEA did not add anymore amount in April, resulting in a decline in April from March. Without the $50 billion in March, wage income would have risen 0.4 percent in April.
Personal consumption expenditures (PCE) rose 0.5 percent in April, led by increased spending on services. Overall inflation, as measured by the PCE deflator, rose 0.3 percent in April. The core PCE rose 0.1 percent in April.
The Conference Board Consumer Confidence Index rose to 108.0 from 106.3 in April. Compared with the University of Michigan consumer sentiment measure, the Conference Board's measure assigns more weight to the labor market and less weight to personal finances, including energy prices. In May, consumers modestly upgraded their assessment of labor market conditions while gasoline prices rose. The percentage of respondents calling jobs "plentiful" was unchanged while the share saying jobs are hard to get declined.
The University of Michigan Consumer Sentiment Index was 88.3 in May -- up from April's 87.1. The University of Michigan confidence index has fallen more than some other confidence indices since the beginning of the year but appears to have stabilized, as the index has moved in a narrow range since February.
Interest Rate Outlook:
Yields on long-term Treasuries steadily increased over the past month amidst signs that the U.S. economy is poised for a strong rebound in the current quarter following an anemic growth in the first quarter. The bond market has also sold off in response to the rally in the equity markets. Yields on Treasuries across the curve are at multi-month highs. The yield on 10-year Treasury note hovered around 4.96 percent by Friday afternoon -- 10 basis points higher than the rate on the previous week. The rate is now at the highest level since mid-August 2006.
Next Week:
Monday - April factory orders;
Tuesday - May ISM non-manufacturing survey;
Wednesday - First quarter productivity and costs;
Thursday - April wholesale inventories and consumer credit; and
Friday -April trade deficit.
Orawin Velz
Director, Economic Forecasting
June 1, 2007