The economic outlook from John Fernald of the San Francisco Fed:
FedViews, by John Fernald, FRBSF: John Fernald, vice president at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:
After sharp declines in home sales since mid-2005, recent indicators suggest that housing demand may be stabilizing. Sales of new and existing homes appear to have bottomed out, and consumer attitudes towards home-buying recovered somewhat in the fourth quarter.
In contrast, forward-looking indicators of homebuilding have generally continued to trend down. Housing starts bounced up a bit in November after a very sharp fall in October. But permit issuance for new homes has continued to fall.
One reason to expect further reductions in homebuilding is that the supply of homes on the market remains high. Inventories of both new and existing homes (measured as a ratio to monthly sales) are up sharply since 2005, suggesting that builders are still dealing with an overhang of home supply. Existing home inventories have, in the past, tended to lag new home inventories. This lag probably contributed to persistent downward pressure on housing prices in the early and mid-1990s.
Consumer spending remains strong, suggesting that adverse spillovers from the housing slowdown remain contained. In mid-2006, real consumption growth slowed markedly. But the recent consumer spending data have been solid.
Other indicators have been more mixed. For example, orders for nondefense capital goods excluding aircraft came in on the weak side, suggesting some weakness in equipment and software investment; but net exports in November were stronger than expected. On balance, these indicators are consistent with solid growth outside of residential investment.
A reason for optimism about the outlook is that employment continues to grow, which should provide support for household income and spending. In December, payroll employment rose by 167,000 jobs. The unemployment rate remained at 4-1/2 percent. Hence, the job market still appears relatively tight.
Energy prices provide another reason for optimism. Oil prices have fallen about $20/barrel from their peak last summer. Natural gas prices have also come down recently. Hence, less of nominal household expenditure is tied up in paying for gasoline and other energy products, leaving more disposable income to spend on non-energy goods and services.
Outside of residential investment, GDP growth is projected to remain solid. Overall GDP growth has been held down by falling residential investment, which pulled growth well below trend in the second and third quarters of 2006. As the drag from the housing slowdown diminishes, GDP growth is projected to pick up gradually over 2007 and 2008.
Core inflation (measured, for example, with the personal consumption expenditures price index excluding food and energy) has been elevated for some time. In recent months, the year-over-year inflation rate has turned down a bit. Indeed, looking over the past three months, inflation has been running below 2 percent. Of course, in the past several years there have been other periods when, for a few months, inflation appeared tame, so it’s too early to say that inflation is under control. But, the recent data are in the right direction and provide some reassurance that core inflation may have peaked.
Upside risks to the inflation outlook remain. One risk is that, with tight labor markets, firms might see rising labor costs and then try to pass these cost increases through to prices. In fact, one measure of labor costs, compensation per hour in the nonfarm business sector, spiked up earlier this year but receded somewhat in the third quarter; that measure remains at a high level. An alternative indicator, the employment cost index, remains more contained, though it did pick up in the third quarter.
Another inflation risk is that productivity growth might slow. If labor costs rise, but the cost increases are offset by productivity gains, then firms might not try to pass those cost increases through to prices. Indicators of productivity for the entire nonfarm business sector and for nonfinancial corporations have diverged recently. In the nonfarm business data, productivity gains have slowed sharply. But in nonfinancial corporations, productivity growth has remained solid.
The divergence in the two productivity indicators reflects differences in source data, and it is unclear which is more reliable. A reasonable interpretation is that, although slowing productivity growth remains a risk factor for the inflation outlook, there are reasons to downweight the apparent slowdown in the nonfarm business figures.
On balance, core inflation is projected to continue moderating over 2007 and 2008, moving consistently below 2 percent by the end of 2008. Overall inflation is likely to be more volatile, reflecting the impact of recent declines in energy prices.
With the data on economic activity generally coming in above expectations, financial markets have pared back expectations that the Federal Reserve will reduce its fed funds target before next summer.
The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System.