Housing starts and all that

Housing starts are down! The New York Times reports:

"New home construction dropped to its slowest pace in five months and permits for building had their biggest monthly drop in almost six years in October, the government reported today, providing more evidence of a housing slowdown. Though not yet conclusive, a stream of reports in recent weeks strongly signals that the nation's long housing boom is coming off spectacular peaks and may be headed for far slower growth or even a decline. A monthly report from the Commerce Department today showed that builders started home construction at an annual pace of 2.01 million in October, down 5.6 percent from September. Local authorities issued 6.7 percent fewer building permits in the month, at an annual rate of 2.07 million....Mortgage interest rates have been on a steady rise for the last several months. Last week, the average 30-year fixed-rate mortgage carried a 6.36 percent interest rate, up from 5.77 percent at the end of July. Applications for loans for purchase and refinancings have fallen an average of 2.9 percent in the last four weeks, according to the Mortgage Bankers Association. Consumer confidence, as measured by leading surveys, fell for the first two months after Katrina, but the shopping behavior of Americans appears to provide mixed evidence of that. Retail sales, excluding automobiles and gasoline, have grown briskly in recent months, but real estate agents and others in the industry have reported homes staying on the market longer and prices either slowing or falling in some of the nation's hottest markets...."

Also, CPI inflation fell back to tolerable levels in October according to the BLS. CPI inflation and core CPI inflation (inflation minus the effects of food and energy prices) were both 0.2 percent in October (2.4% annual rate). Overall CPI inflation was 4.3 percent overall from October 2004 to October 2005 while core CPI inflation was 2.1%.

So what I see is a cooling off of inflationary pressures as gasoline prices stabilize, and lots of signs of a slowdown in spending: the end of the housing boom would mean less spending not only on new homes, but also everything that goes into new homes like appliances, garden and yard supplies, carpentry, furniture, etc. Housing is very, very important. The decline in consumer confidence and suggests a slowdown in spending in the next few months. The continued stagnation of the stock market cuts off a potential source of new consumer spending. Rising interest rates means rising costs of holding credit card debt, which should further restrain consumer expenditures. The personal savings rate was negative last quarter: eventually households are going to have to start living within their means, which means less consumption. O.k., maybe investment and government purchases will rise due to the rebuilding after Katrina, but these would have to be really big increases, which I don't see happening.

Given this data, I still would support the Fed's continued steady increases in the federal funds rate towards an eventual target rate of around 5 or 5.5 percent. The Fed is right in arguing that even with modest tightening monetary policy is still expansionary. But I would think about changing the wording of the next FOMC statement. After its last meeting the Fed said

"With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

The last sentence indicates that the Fed is more concerned that inflation will jump up in the next few months than that the economy will slow down. This is an important statement, because financial market participants use this as a clue to figure out where the Fed is going to move interest rates in the near future; on the basis of sentences like this, financial markets have been building continued rate increases into financial prices. I'd change the sentence to indicate that the balance of the Fed's concerns are toward a slowdown rather than higher inflation, which would signal markets to anticipate an end to higher rates within the next few months. Which, by the way, is what I think the Gettysburg College Fed Challenge team is advocating even as we speak at their contest in Baltimore. We'll see what the judges have to say about that little piece of wisdom.