By David F. Seiders, Chief Economist, National Association of Home Builders

Strong economic momentum extended into the second quarter of this year, but growth of both real GDP and payroll employment should begin slipping to below-trend rates beyond mid-2006. In the process, the unemployment rate should gravitate upward and get back to 5 percent by mid-2007.

We’re viewing the upcoming slowdown in economic growth and the projected uptick in the unemployment rate as fundamentally positive developments that will help extend the life of the current economic expansion. After all, the expansion is now into its fifth consecutive year, and a lot of above-trend growth has been grinding up slack in labor and capital markets and threatening to generate serious upward pressures on core inflation (excluding prices of food and energy). That’s a real red flag to our inflation-wary central bank.

Inflation okay despite surging energy prices
The Fed has been worried about upward pressures on core inflation from tightening labor markets and soaring energy prices that can make their way into the core through business cost structures. Indeed, history suggests that such pressures are now developing, even if current readings on core inflation look benign.

The core GDP price index showed an annualized gain of 3.3 percent in the first quarter of this year and a year-over-year gain of 3 percent, both on the high side of recent experience. The core price index for the Fed’s favorite inflation gauge, the personal consumption expenditures (PCE), showed an annualized gain of 2 percent in the first quarter and 1.9 percent on a year-over-year basis.

The top of the Fed’s “tolerance zone” for the core PCE price index apparently is about 2 percent. So the Fed presumably is prepared to nip underlying inflation pressures in the bud before they materialize at the consumer level.

Long-term IRs firming up, restoring slope to yield curve
Strong economic indicators, percolating inflation numbers and an obviously resolute Federal Reserve have combined to push long-term interest rates to four-year highs. Indeed, the 10-year Treasury yield has been hanging around 5.1 percent in recent days, and the fixed-rate home mortgage moved up to about 6.6 percent at the end of April.

Long-term rates currently are a bit above NAHB’s estimate for the second quarter and about equal to our forecast for the second half of the year. As long as current expectations for economic growth, core inflation and Fed policy are realized as time goes by, long-term rates should stabilize around current levels.

That’s our current judgment, although our long-term rate forecast could turn out to be too low if term spreads in the yield structure widen out further, imparting more upward slope to the treasury yield curve.

Unsold homes inventories rising
Surveys of home builders and home mortgage lenders have been painting downward trends for home sales since mid-2005, and the official measures of new and existing home sales have been rattling downward irregularly from peaks reached around that time.

Sales of new homes rose in March, but the average for the first quarter was off by 10 percent from the final quarter of 2005 and even further below the third-quarter average. Sales of existing single-family homes (based on closings) were about flat in March, but the first-quarter average was down by about 5 percent from its high in the second quarter of last year. Meanwhile, sales of existing condos were off by 10 percent from the late-2005 highs.

Pending sales of existing homes, based on contracts signed, trailed down during the first quarter, and the March reading was nearly 10 percent below the monthly high last August.

Inventories of homes for sale have moved upward as sales volume has come down. Inventories of new homes gravitated up to a record 555,000 units in March, a 5.5 months’ supply at the current sales rate. Inventories of existing single-family homes moved up to a record 2.70 million in March, a 5.3 months’ supply, and the inventory of unsold existing condo units soared to 494,000: a shocking 6.9 months’ supply.

Housing inflation decelerating, affordability falling
The rate of house price inflation has been decelerating from peak rates posted during 2005.

The median price of existing single-family homes sold in March was up by 7.8 percent from a year earlier, well down from the 15 percent rate of appreciation seen around the middle of last year. In the market for existing condos, year-to-year price appreciation in March was 6.1 percent, down from rates in excess of 20 percent early last year.

The multi-year accumulation of rapid house price increases took a heavy toll on housing affordability last year, and affordability has continued to erode as price appreciation has slowed, partly because of a rising mortgage rate structure.

Indeed, the Housing Affordability Index (National Association of Realtors series) was down by 10 percent in March (year-over-year basis), reflecting a 4.1 percent increase in median family income and a 15.6 percent increase in mortgage qualifying income. The index was down most sharply in the West, where price appreciation has been most robust.

The National Association of Home Builders is a Washington-based trade association whose mission is to enhance the climate for housing and the building industry. Chief among NAHB’s goals is providing and expanding opportunities for all consumers to have safe, decent and affordable housing.