Fed likely to raise interest rates this year

Economy to benefit from higher bond yields, wage increases by Inman News

The Conference Board today reported that after a very long wait, long-term Treasury bond yields have begun to reflect a better outlook for the U.S. economy and the prospect that the next move in the federal funds rate will be up. The forecast also shows a rise in short-term interest rates by 50 basis points in the second half of this year.

The Conference Board, a not-for-profit research organization, reported that manufacturing production is rising at about a 2 percent annual rate, and nondefense capital goods orders, a key investment indicator, have risen 20 percent in real terms since January. Much of the rest of the gain is in machinery orders. Although the pickup in orders is fairly broad- based, high-tech orders are somewhat lagging. High- tech orders, which should recover in the second quarter, are so closely related to the overall level of investment that it would be surprising if this sector didn’t begin to rebound soon as well.

“The picture is a little less encouraging on the housing front,” Gail D. Fosler, executive vice president and chief economist of The Conference Board, said in a statement. “But progress is underway. Demand is slowly coming back to the market. Mortgage applications are up about 17 percent since the low point last August. And the drop in housing starts has been so sudden and dramatic that it has taken inventories down to close to historic averages-though still far above the levels common during the past 10 years.”

But housing is a sector in which long-term forces are shaping the outlook as well as short-term cyclical events, according to The Conference Board. The housing market has enjoyed a decade of strong (booming since 2000) conditions. The strength in housing received not inconsequential help from a long-term trend to lower mortgage rates, which have helped to offset higher housing prices to a great degree.

As a result, the “housing affordability index” has remained high and within a remarkably narrow range of about 120 to 140 since 1993. (An index reading of 100 means that a family earning the median income has enough money to qualify for a mortgage on a median-priced home assuming a down payment of 20 percent).

Beginning in 2004, housing affordability began to plummet as both mortgage rates and house prices rose. The current reading is about 110, which given the definition of the index would not seem to be that low, but the reading is one of the lowest since 1990.

“This weakness in the U.S. housing market is not just a cyclical phenomenon but a response to some very important long-term trends,” Fosler said. “Home prices outpaced average incomes, so there would be a downward bias in any event. As mortgage rates rise, the downward pressure on prices will persist. A surge in wages could solve this problem, but rapid increases in wages would create other problems like inflation that the Federal Reserve would have to address with higher interest rates. While housing is not likely to be a drag on the U.S. economy in the second half of 2007 and 2008, it is also unlikely to make much of a positive contribution for the foreseeable future.”

Consumer spending has certainly been buffeted by slower housing prices and higher gasoline prices, The Conference Board reported. The stabilizing force has been the tight labor market and rising wages. Earnings have slowed, but as in the last cycle, wages will begin to pick up again as growth accelerates and the unemployment rate remains low. Real wage and salary income has been growing at a 2 percent to 4 percent annual rate — with ups and downs due largely to the ebb and flow of gasoline prices. The inflation- adjusted growth of consumer spending has remained generally in the 3 percent to 4 percent range since 2003. But retail activity has been hard hit by the housing slowdown.

These trends explain why the retail sector and particularly the home-improvement retailers have been under so much pressure. “Looking forward, it is reasonable to expect more of the same,” Fosler said. “As growth picks up, so will employment and wages. Consumers should get some relief from high gas prices later in the year as refiners’ margins tend back toward their averages, even if oil prices don’t come down. If oil prices drop, the benefit to the consumer will be just that much greater.”

During the past two to three months, anomalies in both the Producer Price Index and the Consumer Price Index have held down the reported numbers. But the general trend in costs, together with yet another commodity price cycle, suggests that both measures will show higher inflation rates as 2007 progresses.