April 25, 2007

The Eleventh District economy expanded at a moderately strong pace in March and early April. Service sector activity was slightly stronger than in the last report. Consumer spending strengthened and was stronger than expected. Energy activity is still robust, but growth continues to cool. Manufacturing continued to expand at a moderate pace. Agricultural conditions have improved.

The construction industry decelerated more sharply from its vigorous growth of the past year. Real estate markets continue to weaken and, while a substantial amount of building is finishing up, industry contacts expressed concerns about the large inventory of homes and growing supply of offices and apartments. The financial services industry reports that consumer lending continues to soften and a greater percentage of potential borrowers are not qualifying for loans. Commercial lending remained strong, but growth is moderating.

Contacts in many industries expressed cautious optimism about the outlook, noting uncertainty about the effects of problems with subprime lending, home foreclosures and softening real estate markets. Firms doing business nationwide say economic activity in Texas continues to be stronger than in the rest of the country.

Prices
Energy prices remain high and a concern for many industries, putting upward pressure on costs and selling prices. Shipping costs continue to increase to accommodate higher costs for fuel, labor and port fees.

West Texas Intermediate crude oil prices hovered around $60 per barrel during the period, and U.S. inventories fell moderately. Natural gas prices remained around $7 per million Btu, supported by cold weather and rising crude prices. Cold weather reduced inventories of natural gas to about 8 percent below last year's level. However, they remain 25 percent higher than the 5-year average for this time of year. Gasoline prices rose over 40 cents per gallon, pushed up by strong demand and declining inventories. The increase was more than expected on the basis of crude oil prices alone.

Some manufacturers, such as food and transportation equipment, reported rising prices or expectations for higher prices, pushed up by higher input and wage costs. Petrochemical prices rose, boosted by a combination of strong demand and/or higher feedstock prices. Selling prices are falling for other factory products. Softening demand is intensifying competition and putting downward price pressure on most construction-related materials, despite high or rising costs for energy, transportation and raw materials.

Labor Market
Labor markets remain very tight, and some contacts say the labor shortage has intensified. Numerous firms report difficulty finding qualified workers, such as welders, engineers, truck drivers, certified mechanics and financial professionals. Wages are rising in some instances, but in others--such as for lower-skilled jobs in the Austin area--firms say they are understaffed because they can not operate profitably if wages were increased high enough to attract workers.

Layoffs continued to be reported by home builders and some manufacturers, particularly those supplying the construction industry. While downward wage pressure is found in these industries, some firms laying off workers also report difficulty hiring some types of skilled workers and upward pressure on wages for those positions.

Manufacturing
Overall manufacturing activity expanded at a moderate pace. There was little change in demand for paper and food products. Transportation equipment manufacturers reported continued strong demand, with some noting low inventory and a backlog of orders.

Construction-related manufacturing was generally weaker over the past six weeks, although a number of firms said sales growth was unchanged and a few reported a pickup. Softer sales were mostly the result of slowing residential construction, although sales for commercial building have become less robust. A few firms reported that Texas activity picked up in March after unfavorable weather delayed projects in January and February.

High-tech manufacturers reported that growth in sales and orders has been the same or slightly higher since the last survey. There has been some increase in inventories although most respondents say they are close to desired levels. The industry expects sales and orders to remain close to their current moderate pace.

Petrochemical sales increased, boosted by continued strong international and improving domestic demand. Domestic demand has been strong for synthetic rubber. After a slow return from scheduled maintenance, Gulf Coast refineries are now operating at over 90 percent utilization.

Services
Demand for temporary staffing services picked up slightly over the past six weeks. Firms said there was an increase in orders from manufacturing firms and continued strong demand for workers in accounting, administrative, legal and IT services.

The accounting industry reported an increase in demand for their services. Contacts in the legal industry said there was a slight increase in activity, with more corporate and real estate transactions and a drop in work to support bankruptcies. Despite higher costs for wages, insurance and utilities, law firms said they were facing difficulty raising client fees.

The airline industry reported very strong international demand. Domestic activity is good with high load factors, but carriers reported various pockets of weakness in bookings. Capacity is creeping back into the industry, they say, limiting fare increases even though fuel and labor costs are rising.

Railroad cargo volume is strong but softened slightly over the past month. Increased shipments of chemicals and petroleum products partly offset dramatic decreases in volumes of lumber, wood and building products supplying the housing industry. Railroads are working near capacity, and contacts say the industry may not be able to accommodate continued strong volume growth. Trucking volumes increased over the past month, and growth is expected to pick up this year to accommodate shipments railroads are unable to handle because of limited capacity. Small parcel shipping firms say the volume of activity remains solid but continues to decelerate. Container trade volumes climbed over the past month, primarily because of a rise in steel shipments and opening of a new port facility which is attracting foreign traffic.

Retail Sales
Sales increased at a good pace in March, particularly at stores serving higher income consumers. Growth was stronger than expected at several firms, even after adjusting for the timing of Easter compared to last year. Contacts say consumers are spending less of their budget on discretionary and luxury items. Still some retailers were able to raise selling prices and grow margins despite rising input costs. Sales slowed in April, but contacts remain cautiously optimistic that cool weather is temporarily dampening activity. Retailers with revolving credit say delinquencies have increased, but customers are not defaulting. Auto sales met expectations, according to dealers, but there are still high inventories for some types of vehicles.

Construction and Real Estate
Home sales continue to weaken, but demand remains good by historical standards. Contacts say slowing sales is partly the result of tighter lending standards, and cancellations are up sharply. In some instances potential buyers were unable to sell their existing home in another state, such as California or Florida. Inventories are rising for both homes and building lots. While existing home inventories are moderate by historical standards, there is a sizeable supply of new homes, particularly in the Dallas, Fort Worth and Austin areas. Builders are significantly curbing home starts, as the glut of new home inventory is pushing down prices and increasing incentives.

Apartment demand has been unexpectedly sluggish, particularly in Houston and Dallas. Rents are unchanged or up slightly in most markets, with the notable exception of Austin, where occupancy rates are high and rents rising. A significant amount of new construction is underway in most metropolitan areas, and the leasing environment is expected to become more competitive, with even the Austin market expected to soften.

Office leasing slowed over the past six weeks, although rents are still rising. Contacts remain optimistic but note a lot of speculative projects are coming online that may cause occupancy and rental rate increases to level off. Construction of a speculative Class A office building is being considered in Houston. Dallas contacts say investment activity is very aggressive, but investors are expected to pull back if rental growth does not accelerate.

Financial Services
Commercial lending remains strong and ahead of a year ago, but growth is moderating. Credit quality is solid, according to contacts, who say pricing remains extremely competitive, and new players continue to enter the market. Consumer lending has softened, with weakness in auto and real estate loans. Lenders say a greater percentage of loans are being declined because applicants are not meeting lending requirements.

Energy
Energy activity remains robust, but its growth continues to calm from the frantic pace of the past couple of years. The U.S. and Texas rig counts remain at historically high levels, but growth rates are slowing. A number of new rigs are entering the market and putting downward pressure on day rates. Older rigs are being refurbished, repaired, or stacked to await new work.

Slower growth in drilling has allowed the supply of equipment and services to catch up some, which has reduced their prices. Still, backlogs are long, delivery of equipment can be slow and pricing remains highly profitable. High cost of engineering and construction continues to be a barrier to expansion, causing many projects to be delayed or cancelled.

Rigs are leaving the Gulf of Mexico, attracted by higher rates in the international market. High costs and a very high natural gas inventory are encouraging activity to move to a strong and expanding international market-where there are large scale, long-lived, high-margin projects backed by investors with deep pockets.

Agriculture
Heavy rain improved soil moisture and spring planting conditions. Texas corn acreage is expected to be 14 percent above last year, with less planting of cotton and other crops. Increased demand for ethanol has driven up corn prices and encouraged production.

Higher corn prices and tight hay supplies have raised feed costs and pushed down calf and feeder cattle prices. While fuel and feed costs remain a concern, producers say livestock conditions have improved because rain increased forage availability and reduced the need for supplemental feeding.