Two competing trends shape the U.S. economy in the second half of 2006 -- slower economic growth and greater inflationary pressures. The economy began the year strong, growing at an annualized rate of 4 percent in the first half of the year, but is expected to slow to only 3 percent in the latter half.
Meanwhile, consumer prices increased by 5 percent (seasonally adjusted annual rate) in the second quarter compared to a 2.2 percent rise in the previous quarter, fueling inflation concerns. Whether we see increased pressure in consumer prices depend, to a large extent, on the path of energy prices and labor costs. In mid-July crude oil prices reached a new pinnacle at over $78 a barrel. Oil prices have retreated since then; however, conflicts in the Middle East, supply constraints, and high global demand point in the direction of sustained elevation in oil prices for some time to come.
Counterbalancing the upside risk of energy prices to inflation is the lower than expected employment numbers released by the Department of Labor for July. The unemployment rate increased by two-tenths to 4.8 percent as the economy produced just 113,000 jobs, below market expectations. The employment cost index, a broad measure of labor costs, was up only 3 percent over the year ending in the second quarter, suggesting that inflation in labor costs remains contained. P>It is likely that the languid jobs report, coupled with slower growth overall, influenced the Federal Reserve Board to take a much anticipated "pause" in its tightening policy, after 17 consecutive quarter point increases in the federal funds rate.
Slower growth and higher inflation also squeeze the housing sector since family incomes rise more slowly and interest rates move higher. Housing indicators underscore the retreat of the housing sector as the main driver of economic recovery since the 2001 recession. This is not to say that housing activity has petered out; in fact, 2006 should be the third highest level for home sales on record.
And though new single-family construction and home sales continue to decline from the record high set in 2005, residential fixed investment and housing consumption continued to contribute solidly to real GDP growth, at about 6 percent and 10 percent, respectively, in the first half of 2006. Nevertheless, a strong but cooling housing market will not be enough to prevent a retraction in economic growth to below trend levels. Additionally, rising interest rates will continue to put upward pressure on mortgage financing costs, which when coupled with high house prices reduce affordability and lower housing demand.
Homeowners seem to have found a short-term remedy to competing risks in the economy by refinancing their mortgages. Motivated by rising short-term interest rates, borrowers consolidated home equity loans into new first-lien mortgages to reduce mortgage payments. Borrowers with adjustable-rate mortgages are also refinancing in response to upcoming interest rate adjustments.
We estimate that $500 billion in first-lien mortgages and $650 billion in second-liens are scheduled to adjust this year. Even more dramatically, we estimate that $81 billion was cashed out of home equity through first-lien refinancing during the second quarter, up from $74 billion in the first. Home equity wealth gains have been key to supporting consumer spending. As house price appreciation continues to slow, this mechanism for sustaining consumer spending will diminish, leaving homeowners with less wiggle room to balance higher interest rates with slower income growth.
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