Beneath the Noise, a Resilient Demand Trend and Clear Fed Plan
- Available data point to real GDP growth of less than 1% in the second quarter, yet we are looking through the dip: core demand data have been firmer (watch June retail sales on Monday), and a Q2 inventory correction will likely be followed by current quarter re-stocking.
- The sharp upward adjustment in mortgage rates will not derail the housing recovery. The upward trend in new construction is tightly tethered to household formation; and while house price growth may slow, home sales should continue their gradual ascent: affordability remains high even at current rate levels, and expected future rates and prices, as well as rising employment and income security, exert positive influence on demand.
- The FOMC has provided substantial clarity, in our view, regarding the monetary policy path that it intends to follow if the economy evolves in line with its expectations. To anticipate a different course of monetary policy over the next 2½ years, one must hold a different economic outlook (we do not). In contrast, we find little appeal in arguing for a different policy course based on the assertion that the FOMC will end up responding to a given set of economic outcomes in a manner at odds with its stated reaction function.
Q2 growth: look beyond the headline
Estimates of Q2 real GDP growth have fallen by roughly one percentage point over the last two weeks, to less than 1% (annual rate), owing roughly equally to downside surprises in May net exports (goods & services balance $4.8 billion wider) and wholesale inventories (-0.5%). Given these sources, anticipated weakness in the release of Q2 growth (due July 31) will not be indicative of underlying trends in the economy. We expect 2.7% growth in Q3.
- Outright inventory liquidation is unsustainable, so a current quarter growth contribution from wholesale inventories (and from aggregate re-stocking, including manufacturers and retailers) likely.
- It is unusual for inventories and net exports to make contributions to growth in the same direction within a given quarter, as appears to have occurred in Q2: since some inventories are imported and others are due for export, a slower pace of inventory building (or outright de-stocking) is generally associated with a narrower trade gap.1 It is possible that the trade gap narrowed sharply in June, shifting net exports to a positive contributor to growth, erasing the apparent anomaly.2 Alternatively, the unusual occurrence could repeat in Q3, but with the sign reversed as inventories and net exports both add to growth.
- Available data indicate core domestic demand (consumption, housing, business fixed investment) holding up better, tracking near 2½%. Indeed, both the inventory draw and import surge could reflect stronger demand than has yet been reported. We look to June retail sales (due Jul. 15) and durable goods data (Jul. 25) for evidence with which to test of this hypothesis.
Source: Bureau of Economic Analysis, Haver Analytics
Limited risks to housing from higher rates
The 120 basis point April-May rise in mortgage rates has prompted concern for the viability of the housing recovery. Our highest-confidence view on this subject is that the rise in borrowing rates will not disrupt the recovery in construction of new housing units. From the broadest perspective the current pace of housing starts is too low relative to the rate of household formation. An anticipated June rise in housing starts (Jul. 17) July consolidation of June’s sharp rise in builder sentiment (Jul. 16), would support this view. In addition, it stands to reason that higher mortgage rates will cool the recently heated pace of home price inflation, in part by tarnishing the economics of investor purchases.
Nonetheless, we are skeptical that the current level of rates will undermine the gradual recovery in home sales (although a short-term setback is certainly possible – the Mortgage Bankers Association index of mortgage applications for home purchase has fallen 6.1% over the past two weeks to a four-month low). Even at current interest rates, mortgage carrying costs are low by historical standards: principal and interest on a mortgage financing 80% of the median-priced home has risen from an all-time low 11.9% of median family income in January to an estimated 16.3% in July, but this level is still well below the pre-bubble (1993-2004) average of 19.4% (Figure 2), corresponding to an affordability index of 128.9%.3 Particularly with affordability still attractive by historical standards, the negative impact of the recent increase in rates is likely to be outweighed by the positive influences of expected future rates and prices, as well as by employment and income
security.
The Fed’s message has been clear, deal with it
Here’s the Fed’s plan, (broadly) same as it ever was:
- Begin the wind-down of asset purchases later this year if incoming data are broadly consistent with the FOMC’s forecast. (We expect the first tapering step no later than the Sep. 17-8 meeting.)
- Cease asset purchases around mid-2014 (assuming that the unemployment rate has declined to “the vicinity” of 7% “with solid economic growth supporting further job gains”4).
- Begin discussing rate hikes when the unemployment rate reaches 6.5%5; FOMC projections imply a 6.5% average unemployment rate in the first quarter of 2015.
- Begin to raise policy rates in 2015, and proceed to “remove accommodation” – raise rates – gradually thereafter.6
Now hear this!
In the FOMC policy statements, removal of policy accommodation has always referred to raising policy interest rates, not to any aspect of balance sheet policy. There is no contradiction between winding down asset purchases and concluding “that highly accommodative monetary policy for the foreseeable future.” 7
The FOMC has provided substantial clarity, in our view, regarding the monetary policy path that it intends to follow if the economy evolves in line with the Committee’s expectations. To anticipate a different course of monetary policy over the next 2½ years, one must hold a different economic outlook (we do not). In contrast, we find little appeal in arguing for a different policy course based on the assertion that the FOMC will end up responding to a given set of economic outcomes in a manner at odds with its stated reaction function.
1 This relationship – quarterly contributions to growth from inventories and net exports of opposite signs – held 70% of the time over the past 10 years.
2 June business inventory and international trade data will not be released until after the July 31 initial estimate of Q2 GDP. The Commerce Department will incorporate its own estimates of these and other missing data in that first estimate of Q2 GDP.
- 3 At this level of affordability, median income is 128.9% of the level required to qualifying for 80% financing of a median-priced home.
4 Ben S. Bernanke, “Press Conference,” June 19, 2013. Transcript from Roll Call, Inc., via Bloomberg.
5 Subject to the FOMC’s 1-2 year inflation forecast not exceeding
2.5% and inflation expectations being contained.
7 Eighteen of 19 FOMC participants expect the Fed funds target rate to have been increased at least once – by 25 basis points to 0.5% - by the
end of 2015. Forecasts for the 2015 Q4 average funds rate range from 0-.25% to 3.0%, with a median of 1.0% and mean of 1.34%.
7 Ben S. Bernanke, “Question and Answer Session at a Conference
Sponsored by the National Bureau of Economic Research, Cambridge, MA, July 10, 2013. Transcript from Roll Call, Inc., via Bloomberg.
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