EconSouth (Fourth Quarter 2006)
Housing, Energy Loom Large in '07
Over the past year, the performance of energy and housing markets exerted significant influence on the U.S. economy. These factors will again play large roles in the outlook for the coming year.
If discussions about the U.S. economy had two dominant themes in 2006, they centered on energy prices and housing markets. That centrality will continue unabated in 2007 as both factors—and the uncertainty that surrounds them—remain influences on economic performance.
Energy prices fluctuated in 2006
Gasoline prices have been moving higher at a double-digit rate since 2003 (see chart 1). This increase reflects the combination of demand growth, limited spare capacity in the refining industry, and the risks of disruption to the supply of crude oil. In July 2006, the average price for a gallon of regular unleaded gasoline reached a record $2.98, almost twice the $1.51 average price in July 2003.
But a mild hurricane season in the Gulf of Mexico, the easing of the Israel-Lebanon crisis, and the earlier-than-expected resumption of production in the Prudhoe Bay oil field in Alaska, following repairs in the summer to a leaking pipeline, helped pull oil prices down during the fall. By November, the spot price for a barrel of West Texas intermediate crude oil was $59, $14 lower than its $74 peak in July, and the average price of a gallon of regular unleaded gasoline had dropped to $2.23.
Natural gas prices had more than doubled in the wake of the disruption to supply that Hurricanes Katrina and Rita caused (see chart 1). But the mild 2005–06 winter and the restoration of supply capacity helped bring prices down during 2006. By late October, natural gas prices had returned to near the prehurricane levels of 2005, and inventories were relatively high.
These energy price declines mean consumers and businesses are spending relatively less on transportation and other energy-related items and can spend more on other goods and services, in the process improving their confidence in the economic outlook. Indeed, based on initial Commerce Department estimates, monthly growth in consumer spending appears to have improved during the fourth quarter of 2006, after a lackluster third quarter performance.
But the Energy Information Administration expects oil prices to move moderately higher, to around $65 per barrel by the end of 2007. Supply uncertainty, especially given the risk of disruptive geopolitical events, and robust global demand underlie analysts' forecasts. This anticipated price trend suggests that the energy sector will continue to exert a moderating influence on economic growth in 2007, albeit less of a drag than it did in 2006.
Housing market's pace to play a large role
The housing sector was the other major economic story in 2006. Nationally, new single-family home sales were down 25 percent in October from a year ago, and sales of existing homes fell 11 percent (see chart 2). The Census Bureau also estimated that the inventory-to-sales ratio for new homes was up 60 percent from a year ago to the highest level in 11 years. By some measures, house prices are also falling. The National Association of Realtors (NAR) reported that the median price for existing single-family homes in the United States fell 3.5 percent in October 2006 from a year earlier. However, NAR measures actual transaction prices and does not take into account changes in the mix of homes being sold over time, so NAR's research in this case might reflect declining sales in some large, higher-priced markets.
The Office of Federal Housing Enterprise Oversight (OFHEO) maintains a repeat-sales price index for existing homes that compares the price of a house to the price that same house sold for previously. This index suggests that the average sales prices for existing homes are still rising, albeit more slowly than in the past few years. OFHEO's measure increased at an annual rate of 1.5 percent in the third quarter of 2006 and 6 percent from a year earlier. This change was the smallest four-quarter increase since 1999.
Builders have responded to the lower sales and rising inventories by paring back construction, especially of single-family homes. The Census Bureau estimates that single-family starts in October were about 35 percent below the peak seen in January 2006, and single-family permit issuance fell to its lowest level in nearly five years. Interestingly, the decline in residential building in 2006 was not reflected in the multifamily sector, where new construction was down by only 3 percent in October.
Indicators of future sales of single-family homes are also weak. The November National Association of Homebuilders' index of expected sales remained near its lowest point since January 1991. Payrolls also reflect the reductions in residential construction. The Bureau of Labor Statistics (BLS) reported that the number of specialty trade contractors employed in the residential sector declined by about 100,000 over the first 11 months of 2006 after adding more than 150,000 jobs a year in 2004 and 2005. Additionally, financial firms providing real estate services have cut employment in response to lower demand, and manufacturers of homebuilding products are experiencing slower orders.
Much of the uncertainty surrounding the overall economic outlook relates to the magnitude and duration of the housing slump and its consequences for other sectors of the economy. The decline in housing starts translated into a reduction in real residential investment in the third quarter and a drag of around 1 percentage point on the annualized quarterly rate growth in real gross domestic product (GDP). Some forecasters expect a similar drag in the fourth quarter of this year and possibly into early 2007.
The large backlog in unsold homes suggests that home construction will be slow to turn around, but most analysts expect the declines in residential investment to moderate during 2007. Housing demand should also improve in 2007, supported by relatively low mortgage rates that still prevailed in the fourth quarter of 2006 and projections for solid income growth.
Real GDP outlook is modest
Looking ahead, most forecasters anticipate that real GDP growth for 2007 will be in the range of 2 to 3 percent. This growth rate would be slower than the average GDP growth of 3.9 percent in 2004 and 3.2 percent in 2005 and 2006 and would be tied to anticipated further declines in residential investment. Few economic forecasters expect a more general economic slowdown at this time; most believe that economic sectors other than housing will contribute to growth. One area where continued growth is anticipated is capital spending by businesses, which appears to have expanded at close to a 9 percent pace in 2006, partly boosted by sales of heavy trucks that will meet requirements contained in new regulations from the Environmental Protection Agency.
While that pace is unlikely to be matched in 2007, both nonresidential construction and spending on equipment and software should advance at a solid rate, supported by strong corporate earnings. In addition, increased defense spending is likely to increase federal outlays, and robust international demand should stimulate exports.
The inflation outlook in 2007
Measures of inflation, such as the consumer price index (CPI) and the price index of personal consumer expenditures (PCE), continued to increase during the first part of 2006 because of higher energy prices (see chart 3). These inflation measures moderated in the latter part of 2006 as energy prices retreated.
But even when stripping out the volatile food and energy components, the core CPI and PCE measures still moved higher through most of 2006 (see chart 4). This performance partly reflects the eventual pass-through of higher energy costs to other goods and services. Also, following a typical pattern, as the demand for homeownership has waned, the demand for rental accommodation has intensified. Rent prices are a large component of both the core CPI and PCE measures, so rent increases during 2006 also helped push the inflation measures higher.
Despite the troublesome short-run trends that pushed inflation higher, most forward-looking measures of inflation, such as surveys and inflation-indexed Treasury bond spreads, suggest that inflation expectations remain anchored. Indeed, the consensus forecast for core inflation is that it will track lower during 2007, in part because of the diminished upward pressure from higher energy prices and smaller increases in rents as housing markets stabilize. Nevertheless, both the CPI and PCE core measures will likely remain above 2 percent in 2007.
This article was written by John Robertson of the Atlanta Fed's research department.