Tim Duy reviews the latest housing data and the Fed's reaction to it in a Fed Watch:
More Data Watching, by Tim Duy: The recent spate of housing data confirms the anecdotal evidence – while there may be some pockets of resistance, the national housing market is quickly reversing course. Still, as I noted earlier this week, the Fed’s reaction to date appears to be muted. How long will they maintain such a complacent posture? In general, I think the answer is: Longer than you might expect.
The key, of course, is to what extent housing undermines the rest of the economy. I think there is little debate that the first impact (outside of residential investment) will be on the consumer, although the Wall Street Journal appears to believe we are still kicking this around:
A key concern, economists say, is whether the softening housing market will hurt consumer spending. In recent years, consumers have used extra cash from mortgage refinancing to fuel extra purchases, and the soaring value of their homes has given them a sense of wealth that could prove ephemeral if the decline in sales accelerates.
I believe it is more accurate to question the extent of the impact, not the impact itself. Two channels leap to mind, the impact of housing related employment and the impact via higher mortgages and reverse wealth effect. Presumably, both will be captured in consumer confidence, which took something of a drop in August, according to the University of Michigan. Nouriel Roubini points to the decline to reinforce his recession call for 2007:
First, consumer confidence is sharply down as consumers are in a foul mood. No surprise as the three bears of slumping housing, high oil and the delayed effects of rising policy rates are beating down a consumer with falling real wages, negative savings, high debt ratios, rising debt servicing ratios and mediocre job growth.
I can’t argue too much with this point, expect to say that the magnitude of the shift in consumer confidence to date is consistent with simply a slowdown, not a collapse of household spending. Recall the tight relationship between confidence and real spending:
Using the complex system of “eyeball” econometrics, the confidence data is pointing to year over year growth in spending of somewhere in the 2-3% range. Not exactly a disaster and necessary if you believe the US economy needs to undergo a rebalancing. The Fed will note this as well: Remember that the Fed anticipates the economy will slow, and that the slowing will be felt most in the household sector. Moreover, considering that the base of spending activity depends on incomes, the Fed will not foresee a collapse in consumer spending in the absence of a sharp reversal in the job market. The four week moving average of initial job claims, standing at 315,250, is not yet supportive of such a reversal.
This, of course, is not meant to imply that the slowdown will be painless. Rebalancing will require that some blood be spilled. Today, for example, Williams Sonoma warned for the second time, noting that “…after five weeks in home with our new Pottery Barn fall catalog, we believe there is a greater macroeconomic issue also affecting this business.” This is particularly notable because their target market is households with income of $75,000 and up, suggesting that the pain is spreading. Although we see lots of stories about lower income people caught up in the housing bubble, my guess is that there is going to be more pain than people anticipate at the higher end of the income scale.
And, as I said in my last piece, the automakers are already feeling the pain, once again confirmed by July’s advance durable goods report. New orders for motor vehicles and parts slipped 7.0%, while shipments slipped 7.4%, both extending the previous month’s declines. This will come as no surprise to policymakers, who will likely instead turn their attention away from the headline decline and to the less volatile indicator, capital goods excluding aircraft and defense. New orders for this core indicator posted a 1.5% gain, a third monthly gain of more than 1%. And, perhaps more importantly, shipments gained 1.3%, compared almost no growth the previous two months. Why is this important? Back to Chicago Fed President Michael Moskow’s most recent speech:
In the second quarter, GDP growth slowed to 2-1/2 percent, due to weaker household spending and business investment. I believe a good portion of this moderation was probably due to transitory and one-off events, such as the timing of shipments in transportation and communications equipment. (emphasis added)
The jump in capital goods shipments should pull the base for investment spending higher, reversing the decline signaled in the second quarter GDP report. In short, the durable goods report will support Moskow’s contention that the underlying trend in investment spending remains healthy, and help him dismiss the Eeyores.
All in all, the Fed will largely read the data as consistent with their expectation of a soft landing. Right now, however, it doesn’t seem like the financial markets are buying the Fed’s vision of the future. As I write this, the 2 year Treasury yields 7bp more than its 10 year countertop, while the 10 year TIPS spread has narrowed to 253bp. The latter is good news for the Fed on the inflation front, but the combination indicates that markets suspect more slowing in the future than the Fed anticipates. What is the disconnect?
Again, I think we come full circle to the housing question – the Fed is just not ready to believe – or admit? – that the housing slowdown will spread deeply into the economy. Financial market participants, in contrast, are increasingly worried that the housing slowdown will come to look more like the tech collapse sooner or later. Moreover, the Fed is acting as if the economic behaves linearly, and as such can easily shift down to a lower growth trajectory. But Brad Delong reminds us that there are good reasons to worry about nonlinearities:
Ever since then I have firmly believed that modeling the macroeconomy through a set of linear equations has to be the wrong road: that the economy is a qualitatively different animal when employment is shrinking than when employment is growing and there are still unemployed workers eager to work at prevailing wages, and yet a different animal again when the economy is growing and there is "full employment." I think recession begin and end dates are important things to understand when they are used as markers for the phase transitions the macroeconomy undergoes.
Of course, aggregate employment is not yet shrinking, but NFP growth has slowed. But the essential point remains – the economy is in transition, and we don’t yet known how that transition will ultimately play out.
The Fed, of course, is not ignoring these risks. Because there is a nontrivial risk (in my mind, 30-40%) that it plays out badly, the Fed is effectively on the sidelines. To be sure, expect policymakers to keep tossing the “inflation risk” story around. As long as core inflation forecasts are on the upside of 2%, Bernanke & Co. will keep reminding us that they could still raise rates. Lacking clear evidence that underlying growth will slip well below potential, policymakers will maintain an inflationary bias in their policy pronouncements. But with plenty of evidence that the slowdown in housing is intensifying and a job market that has shifted to just treading water, not to mention a well inverted yield curve, I have trouble seeing a rate hike in September.