The week's economic reports

Falling home prices, plunging consumer confidence, and a modest upward revision to first quarter real economic growth highlighted the week's economic reports. Stocks and bonds ended with the S&P 500 Index up 1.8 percent to 1,400, now down 4.6 percent for the year, and the yield of the 10-year U.S. Treasury note rose 21 basis points to 4.06 percent.
New Home Sales: Sales of new homes rose modestly in April, up 3.3 percent from a downwardly revised annualized rate of 509,000 in March to 526,000. From the unrevised rate in March, sales volume was flat and on a year-over-year basis, sales are down 42 percent, the steepest annual decline since the early 1980s.

Though it is always difficult to discern the true sales price after factoring in builder incentives, the reported median sales price rose 9.1 percent for the month, posting a surprising increase of 1.5 percent from year ago levels.
The inventory of unsold homes remains quite high, down slightly from 11.1 months in March to 10.6 months in April and, as noted on many occasions before, this sales rate/inventory combination is the most important metric to be considered regarding the future direction of home prices. Until inventory comes down, there will continue to be pressure on prices.

The S&P Case-Shiller Home Price Index was released last week showing even bigger declines in property values (see Home prices: How low can you go?). The 20-city index dropped 2.6 percent from February to March, now down a whopping 14.4 percent from year ago levels. Six former housing bubble hot-spots showed year-over-year price declines of more than 20 percent - Las Vegas, Miami, Phoenix, Los Angeles, San Diego, and San Francisco - with only Charlotte, North Carolina posting an annual gain of a modest 0.8 percent.

While home sales may form a bottom in 2008, there is a near unanimous consensus that home prices will continue to decline throughout the year and probably well into 2009, perhaps beyond.

Durable Goods Orders: Orders for durable goods fell 0.5 percent in April after a decline of 0.3 percent in March. Excluding the always volatile transportation sector, new orders rose 2.5 percent paced by a 28 percent increase in electrical equipment. Within the transportation group, new orders fell 24 percent for nondefense aircraft and 3.3 percent for autos.

From year-ago levels, durable goods orders are down 3.4 percent - a clear indication of continuing weakness in manufacturing.

Gross Domestic Product: It appears as though government reported "inflation adjusted" economic growth will remain positive during the first quarter of 2008 as the "preliminary" estimate of real GDP (the second of three estimates for Q1) came in at an annualized rate of 0.9 percent.

This is an improvement on the 0.6 percent rate reported a month ago, and on a year-over-year basis, real GDP now stands at 2.5 percent. The "final" estimate will be released at the end of June and then the "advance" estimate of economic activity in the second quarter will be reported at the end of July.
The improvement in the headline number reflects a narrower trade deficit and higher levels of inventory than first estimated. As has been seen in the monthly reports on international trade, lower imports (despite higher oil prices) have been the driving force for the trade gap narrowing.

The first quarter GDP price index was unchanged at an annualized rate of 2.6 percent - this is the dubious "GDP deflator" responsible for transforming "nominal" growth to "real" growth through a rather complex calculation. PCE inflation came in at 3.5 percent, which is mostly in line with the Consumer Price Index over the same period, though both of these measures of "inflation" are increasingly suspect as well.

Current estimates for second quarter growth are mostly in positive territory, largely a result of an improved trade deficit and steady government spending. Masked somewhat by rising gasoline prices, growth in consumer spending is declining but it remains positive - this holds the key to future economic activity in the U.S. as many are now expecting the consumer retrenchment to gain pace.

Consumer Confidence/Sentiment: Both the Conference Board's consumer confidence survey and the Reuters/University of Michigan consumer sentiment survey continue to indicate major distress amongst consumers, the former falling to a 16-year low and the latter visiting levels last seen in 1980.

In its latest reading, consumer confidence fell five points from 62.3 in April to 57.2 in May and one-year inflation expectations rose to a shocking 7.7 percent. Those saying that jobs are plentiful fell to 16.3 percent while those saying they are hard to get rose to 28.0 percent.

The consumer sentiment survey confirmed a mid-month reading of two weeks ago, falling almost three points from 62.6 in April to 59.8 in May with a similarly elevated outlook for inflation over the next year of 5.2 percent.
Note that the two readings on "inflation expectations" contained in these two surveys have always been off by a couple percentage points or more, but they have tracked each other reasonably well over time. Along with the difference in yields between U.S. Treasuries and "inflation-protected" Treasuries (TIPS), these survey responses are a major source of the Federal Reserve's "inflation expectations" metric, a key consideration when they deliberate on monetary policy.

For many years these measures were in the two to four percent range with only a temporary move upward after the 2005 hurricanes pushed energy prices sky high. The recent move, however, driven by both energy and food, has been much more pronounced and sustained. The Fed is understandably concerned about these statistics as "anchoring" inflation expectations has been an integral part of monetary policy for some time. It is significant that consumer "inflation expectations" are now two to four percentage points higher than the Fed's inflation estimates.

Summary: Due to the size and nature of the upward revision to GDP - less imports and rising inventory - it's hard to get too excited about economic growth in the first quarter particularly when considering how big a role the inflation statistics play in determining whether the final number is positive or negative. Previously, most analysts were projecting at least one quarter of negative real growth in the first half of the year, now it appears that there will be none - annualized growth of between 0 and 1 percent is now the consensus for the second quarter.

Meanwhile, home prices continue to plunge along with consumer confidence. As the mood of the consumer is highly correlated with gasoline prices, unless home prices head back up and prices at the pump head back down (both of which seem very unlikely, at least in the near-term), there will likely be continuing pressure on the consumer sector that will show up during the second half of the year, a time when many economists are forecasting a rebound.

As the election season heats up, it will be interesting to see how the role the consumer is framed in the expected debate over the health and the future of the U.S. economy.

The Week Ahead: The coming week will be highlighted by the ISM manufacturing report on Monday and the labor report on Friday. Also scheduled for release are reports on construction spending on Monday, three reports on Wednesday - ADP employment, productivity/costs, and ISM nonmanufacturing, ending the week with a report on consumer credit on Friday.

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The Economist and their brick metaphors

Aside from being the only known previous sighting of The Economist's brick metaphor for housing, the remarkable thing about the magazine cover you see below is that it is three years old! Clairvoyance perhaps?
Not really.

At the time in 2005, it looked as though house prices in the U.K. were about to drop like a brick, but then they staged a miraculous recovery only to drop again in recent months.

A report in today's Wall Street Journal has a nice little graphic to help explain the 2005 Economist cover above:

U.K. home prices took their sharpest tumble in May in the 17 years of recorded data, raising the risk that the world's fifth-biggest economy will go into a recession, some economists say.

House prices fell 2.5% in May from the prior month, the largest decline since the Nationwide Building Society's monthly index began in January 1991. Prices fell 4.4% from a year earlier, the biggest drop on this basis since December 1992, the U.K.'s last recession.

Prices have fallen for seven months in a row, the longest stretch since 26 years ago, when a price crash saw thousands of homeowners slip into negative equity, when their houses were worth less than the debt they owed on them.

As for The Economist, look for another brick on the cover (or some variant on the theme) sometime in the weeks or months ahead.

They appear to be getting warmed up in the current issue when looking at the U.S. home price data, but they'll probably turn their attention inward in short order:

“A DESTABILISING contraction in nationwide house prices does not seem the most probable outcome...nominal house prices in the aggregate have rarely fallen and certainly not by very much.” Alan Greenspan's soothing, if rather verbose, words on America's housing market in 2005 rank high on history's list of infamous predictions. But to be fair, most American economists shared his view that it was highly unlikely that average nationwide home prices would drop. That was the sort of thing that happened only during a deep depression, like the 1930s.

Unfortunately, new figures this week reveal that house prices have already fallen by more over the past 12 months than in any year during the Great Depression.
...
In nominal terms, the average home is now worth 16% less than at the peak in 2006, and the large overhang of unsold houses suggests that prices have further to fall. If so, this housing bust could well see a bigger cumulative fall in prices than the 26% real drop over the five years to 1933. Most people would call that a pretty destabilising contraction.

Hmmm... managed to get that Greenspan pearl of wisdom in both of today's posts so far ...

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The new American investor

While not defending the Garcia's, their decision-making process and its fateful results are certainly more easily understood when considered in the context of a nation-wide credit and debt orgy over the last ten or twenty years.

Really, what did ivory tower economists and politicians expect ordinary Americans to do when the credit spigot was turned on them earlier in the decade?

Watching from afar for all these years - the junk bond boom, the Japanese stock boom, the S&L housing boom, the internet stock boom - this was their chance to "invest" in something they understood - real estate.
This comment tells you about all you need to know about the plight of the Garcias who, like many others a few years back, borrowed against the equity in one house to buy an even bigger and better one thinking that perpetually rising real estate prices would make them wealthy:

“We wanted to make it an investment,” Ms. Garcia said.

In their defense, a couple years ago, along with nearly all of Main Street, most of Wall Street (most importantly the rating agencies) also thought that home prices would climb higher in perpetuity.

It really was conventional wisdom at the time, former Fed chief Alan Greenspan counseling "nominal house prices in the aggregate have rarely fallen and certainly not by very much".

In addition to having lost the "investment" to foreclosure, also like many others, the Garcias are facing a hefty tax bill. This report in the New York Times explains:

Some of the biggest losers in the real estate slump are not purchasers of mansions they could not afford. They are buyers of second homes — or third ones, for that matter — who are sitting on a tax time bomb.

Many of these people will lose their properties in foreclosure and then stagger into bankruptcy under the weight of a sizable tax bill. While Congress has granted some tax relief to people who lose their primary homes, there is no such aid for those who fall behind on payments on a getaway condo in Las Vegas, a retirement home on the Florida coast or an old house that they are renting out for income.

Bankruptcy lawyers say they are seeing a wave of foreclosures among owners of second homes in such a position, owners who thought they had found sound advice for financial security.

Two years ago, Lilia Garcia and her husband, Jesus, bought their dream house in Linden, Calif., for $535,000 and financed it in part by taking out a bigger loan backed by their previous house in nearby Stockton. They decided to hang onto the Stockton house and rent it out, believing that it would more than pay for itself and could be sold years in the future to help pay for college for their two children.

This is the "ownership society" in reverse gear, apparently.

The new American investor is experiencing a major setback.

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Real economic growth and inflation

Curious about what "inflation adjusted" economic growth might look like with different levels of inflation, whipping up one more animated .gif seemed an appropriate thing to do.The second frame - Inflation as Stated - is what the official Commerce Department data indicated this morning.

The range indicated above - from an overstatement of 1 percent to an understatement of up to 3 percent - is based on the views of Ben Bernanke (at the Federal Reserve) and John Williams (at ShadowStats.com).

Though the actual calculation is much, much more complex, for the purposes of this exercise, real GDP is simply adjusted up or down based on the overstatement or understatement of inflation, respectively.

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Maybe an economist can explain this

In trying to understand how we continue to get such freakishly low readings in the price indexes that come out with the reports on economic growth, this data was stumbled upon:
Can anyone explain to me how rising import prices cause the GDP price index to go down this much? I understand the basic principle of how imports/exports are accounted for in the GDP number, but these percent contributions look exceedingly large.

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Still almost childlike in his idealism

According to this report($) in the Financial Times from earlier in the week, it seems that former Fed chief Alan Greenspan remains, in the words of Bloomberg columnist Jonathan Weil, "almost childlike in his idealism" - at least when it comes to asset bubbles.

Some highlights:

Central banks should be wary of trying to deal more aggressively with future asset price bubbles in case they suppress innovation and growth, Alan Greenspan has warned.

"If we want rapid growth in productivity, innovation, standards of living, we may have to accept that there will be periods of turmoil," the former chairman of the US Federal Reserve told the Financial Times.

Rather than try to suppress bubbles, he said, policymakers should ensure that financial institutions were well enough capitalised to withstand the hit from bursting bubbles as well as other shocks.

Haven't we had enough innovation and turmoil in the last ten years?

After successive bubbles in stocks and then in housing, what we probably need now is a good "innovation holiday".

Bubbles, Mr Greenspan argued, were often the by-products of innovation - such as the commercialisation of the internet in the 1990s, or advances in housing finance in the 2000s.

To ask regulators to suppress bubbles would be to ask them either to prevent innovation or to second-guess the value the market puts on it.

"Micro-meddling undermines the basic function of a financial system - that is to direct the savings of society towards its most productive capital investments," he said.

So, in this childlike, idealized parallel world, "innovations" in mortgage finance are still considered a good thing and advances in housing finance that pushed the homeownership rate from 67 percent to over 70 percent was well worth the effort.

Does anyone believe that anymore?

As for second guessing the value assigned by markets, maybe more people should have second guessed home values in 2004 and 2005 - maybe we wouldn't have such a mess on our hands in 2008.

Financial crises "of necessity are unanticipated - if they are not, they are arbitraged away", he said. "We have many international financial stability forums and none of them anticipated the problems of August 9 2007."Mr Greenspan said the most sensible thing to do was "to increase the capacity of our financial institutions to absorb shocks in general. That means more capital".

He should talk to his new employer at Paulson & Co. who made a fortune betting on a subprime collapse last year.

Maybe the real problem is that we need more and smarter arbitragers.

And lastly, some good news - the era of bubbles is over...

In any event, Mr Greenspan said, "I think the probability of sparking another bubble in the next 10 years is very low."

Bubbles, he said, required low long-term interest rates, low inflation and macroeconomic stability. They were "a feature of the disinflationary period that followed the end of the cold war".

Mr Greenspan believes that period is over.

Well, one thing is sure, the Greenspan period is over.

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U.S. Q1 GDP improved - don't get too excited

The Department of Commerce released the "preliminary" estimate for first quarter GDP indicating an improvement to a seasonally adjusted annualized growth rate of 0.9 percent.
Don't get too excited.

The 0.3 percentage point gain from last month's "advance" reading of 0.6 percent was driven by a gain of 0.6 percentage points due to a lower trade deficit combined with a 0.3 percentage point decline in private domestic investment largely due to a change in inventories as shown below.
Today's report is the second of three reports for economic growth during the first quarter - the "final" estimate will be released at the end of June.

The GDP price deflator, used to adjust "nominal" GDP to "real" GDP was unchanged from the advance estimate at 2.6 percent.

With soaring prices for both food and energy during the first quarter of the year, does anyone really believe that a 2.6 percent annualized rate of inflation is the right number to be used to calculate "inflation adjusted" growth?

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