February 2007

Output More Sustainable, Somewhat Less Inflationary Pressure

The U.S. economy ended 2006 with growth edging down to a more sustainable pace and inflation moving down toward more acceptable levels. On the demand side, growth in consumption appears to be recovering from the unusual slowing seen in the fall. The monthly pattern of consumer spending suggests less growth early in the fourth quarter and greater-than-anticipated strength late in the quarter—with more of an effect on growth during the first quarter of 2007. Several housing indicators appear to have stabilized, following earlier large declines, but January data suggest it is not clear whether one-family housing permits have bottomed yet. Purchasing managers report muted gains in new orders in the months surrounding year-end 2006, in line with durable goods order data, which suggest that growth in business investment may decelerate somewhat (Chart 1). Fortunately, export demand has continued to firm of late, with greater demand for aircraft likely to boost exports over the next few years. Supply-side conditions have also become more favorable. Cutting through the effects of unusual swings in weather, energy prices have generally fallen since the summer, reducing cost pressures on firms.

The advance estimate of fourth-quarter GDP growth came in at a surprisingly strong 3.5 percent annual pace, despite being held down by housing, which subtracted 1.2 percentage points off growth in the third and fourth quarters of 2006 (Chart 2). However, subsequent data releases on inventories and net exports suggest that this figure will likely be revised downward. Another caution is that some of the fourth-quarter growth reflected an unusually large surge in nondurable consumption, which may not persist. On the upside, the fourth-quarter inventory drawdown is unlikely to restrain output growth as 2007 unfolds.

Recent data indicate that housing demand may be stabilizing at levels reached in recent months, buoyed by declines in mortgage rates since last summer. However, unusually warm early winter weather may have temporarily boosted home sales and distorted seasonal patterns. In addition, high inventories of unsold new and existing homes will continue weighing on home construction, and the January dip in single-family housing permits makes it unclear whether a bottom has been reached yet (Chart 3). (The latter series is less volatile and sensitive to weather swings than are single-family starts and omits volatile activity in multifamily construction.) Moreover, even if housing permits stabilize at recent levels, the normal six- to eight-month construction period suggests that homebuilding could continue subtracting from GDP growth until the second half of 2007. An open question is whether slower home price appreciation may curtail housing wealth extraction, thereby removing one major source of stimulus to consumer spending as the year unfolds. Home price appreciation has slowed or stopped at the national level, consistent with an outlook in which home prices rise slowly or experience only mild declines on a national basis.

Turning to labor markets, employment gains in November and December helped push up the fourth-quarter pace of job creation to about the 187,000 monthly average rate recorded in 2006. Nevertheless, there are some signs that job growth may moderate this year. For example, nonfarm payrolls grew at a more modest 111,000 monthly pace in January, weighed down by slight job declines in manufacturing and homebuilding. And while warm, early winter weather may have delayed normal winter layoffs by homebuilders, the composition of hiring appears to be shifting toward service-sector industries with good growth prospects, particularly professional and business, education and health care, and leisure and hospitality services (Chart 4). Although weakness in employment has thus far been largely limited to the motor vehicle and homebuilding industries, signs of slow temporary job hiring suggest that employment growth will moderate.

Furthermore, the overall unemployment rate has risen by 0.2 percentage point in the past three months, with the unemployment rate for people age 25 and over having risen by 0.1 percentage point for three months straight. Even though these rates are still low, a comprehensive measure of labor costs—the employment cost index—indicates that overall compensation costs remained moderate last year (Chart 5). Whether this continues is unclear amid anecdotal reports suggesting that wage pressures may be emerging.

Likely reflecting the combination of modest demand growth and lower energy prices, core inflation rates have slowed and appear headed back toward more desirable levels. The core CPI, core PCE and trimmed mean PCE have each moderated toward a 1 percent to 2 percent range. For example, core PCE inflation slowed to a 1.7 percent pace in the last quarter of 2006, following a mild acceleration that likely stemmed from the pass-through of earlier energy cost increases (Chart 6). Nevertheless, on a year-over-year basis, core PCE inflation is still above 2 percent, and further progress in lowering the core inflation rate is desirable (Chart 7).

Recent indicators suggest that the economy will grow at a more sustainable and somewhat less inflationary pace in 2007. The risks to the outlook have become somewhat more favorable on balance. Consumer spending and core inflation have both benefited from last fall’s drop in energy prices, which will help restrain inflation and support consumption in 2007. The latter effect will help offset the reduced stimulus to consumption from housing wealth extraction, which will likely slow in response to the marked deceleration in home price appreciation from the rapid pace seen earlier this decade.

—John Duca and Christine Rowlette