Clifford F. Thies
Clifford F. Thies is the Eldon R. Lindsay Professor of Economics and Finance at Shenandoah University. This article was a presentation to the Clarke County Rotary Club.
February 2007 is the 63rd month of the current economic expansion. Considering that the average economic expansion from 1945 to 2001 lasted 52 months, and that we are now in the 63rd month of the current expansion, the economy must be considered to be doing well.
And a lot of Americans now recognize that we are no longer in recession. In the January 2007 survey of the American Research Group, 46 percent of the public--almost half--said we are not in a recession! So, the word is getting out . . . slowly . . . that we are not in a recession.
I must admit that I'm a little nervous about addressing this year's economic outlook. I looked over my notes from the prior three years, and I see that I've called the economy right three times in a row. What are the odds that, this year, I'll be right again? But, being a gambling man, I say, let it ride.
What I would like to do, in this presentation, is, first, summarize the performance of the economy during the past year; then, take a look at the "deepening" of the expansion, or, how the continuing expansion is now effecting production, employment and income throughout the economy; and, finally, I would like to focus a bit on the housing industry.
To anticipate some of what I will say, first, the Federal Reserve appears to have engineered a successful "soft-landing." The Fed, by raising short-term interest rates during the past two years, removed the building-up of inflationary pressure in the economy, and moderately slowed down the economy, so that we can now look forward to sustained non-inflationary economy growth.
The Fed looks to have removed the inflationary pressure in the economy while not precipitating a new recession. Hence, we call it a "soft landing."
Second, with our long economic expansion, we see that the recovery has made its way into the structure of the economy, strengthening production, lowering unemployment, and raising real wages throughout the income distribution. This deepening of the expansion is also exhibiting itself in an increase in activity in the goods-producing sectors of the economy (and I must say that the weakening of the dollar in the exchange markets has helped in this regard).
To be sure, even with all this good news, several problems or potential problems are out there. I will focus on one of these problems as part of this presentation, namely, the real estate market.
Where We Are in the Business Cycle
The National Bureau of Economic Research, a private group, is generally referred to for the identification of business cycle turning points. According to the NBER, our most recent recession, the 2001 recession, began in March 2001 and ended in November 2001. With the end of that recession we began the present expansion which is now in its 63rd month.
Since the average duration of the eight expansions from 1945 to 2001 has been 52 months, our current expansion of 63 months might be considered to be mature, and it might be supposed that we have fully recovered from the prior recession. Looking at recent trends of production, employment and income, this appears to be the case. However, there seems to be something lacking out there. The strength of the economy is still not fully reflected in consumer confidence, as a result of which, the rate of growth of the economy has been somewhat erratic.
The Index of Leading Indicators, compiled by the Conference Board, another private group, has increased over the past six months, and during the month. Because of this and other information, we can be pretty confident about the current expansion continuing for at least another six to nine months.
Let's look at the overall unemployment rate. The most recent figure we have for the unemployment rate, January 2007, is 4.6 percent. This is low compared to recent history in this country, and very low compared to unemployment in many other advanced economies.
That we have such a low unemployment rate and also have inflation under control challenges the view that some economists still have, that there is a meaningful trade-off between inflation and unemployment. It turns out that, with the right economic policies, we can have both price stability and low unemployment.
Last year, I said there was reason to believe that the unemployment rate, then 4.9 percent, would continue to fall during the forthcoming months, and I was correct. I think that the unemployment rate will continue falling during the next several months.
Having mentioned the rate of inflation, on a November-to-November basis, the inflation rate slowed down from 3.5 percent in 2004 and 2005, to 2.0 percent in 2006. The up tick in the rate of inflation to 3.5 percent in 2004 was disconcerting to the Fed. They didn't want a return of inflationary psychology. And, so, two years ago, they started raising interest rates--or, tightening money--and, as you can see, they got the inflation rate back down to 2.0 percent per year.
With the continuing economic expansion (again, along with a weakening dollar in exchange markets), has come a rebound of activity in the industrial sectors of the economy. According to the Federal Reserve's Index of Industrial Production, the goods-producing sectors of the economy grew last year at a healthy clip, 3.8 percent, as compared to 3 percent and 3.2 percent during the prior two years, and 1.2 percent during 2003. Thus, manufacturing, mining, electricity generation, construction and other such industries are back on the rise.
The recovery of production in the economy is dramatically reflected in the capacity utilization rate of our factories, refineries, power plants and other such facilities. Capacity utilization fell during the prior two recessions (and especially during the most recent one, because the strength of the dollar in exchange markets exacerbated the impact of the fall of aggregate demand on production). But, with the recent increases in industrial production, we are now at something like normal in terms of capacity utilization.
The Real Estate Market
I would now like to focus a bit on the real estate market. There is a lot of talk, nowadays, about the softness of home prices and the glut of unsold homes on the market. Well, I'd like to, first, examine the behavior of housing starts prior to our most recent business cycle.
Prior to the most recent recession, housing starts were strongly correlated with the business cycle. Housing starts were trending down prior to and during each of the five recessions of the 1970s, '80s and '90s. But, housing starts did not fall during the recession of 2001 (although they were falling a bit prior to the recession). Not many people noticed this non-event. In prior recessions, housing starts were falling during the period leading up to and during the recession. But, this pattern did not exhibit itself during the recession of 2001. What happened? (Meaning, what happened so that the usual pattern didn't happen?)
Two things can be mentioned. First, we have a deregulated banking sector. In the past, all kinds of regulations on banks caused a tightening of money to result in a constriction of credit to the housing industry. Today, banks and other intermediaries are able to extend credit to the housing industry based on factors such as the creditworthiness of the loan applicant even during a recession, so the housing industry is no longer devastated by recessions.
Second, the Fed pro-actively lowered interest rates in order to prevent the 2001 recession from getting worse. As a result of low interest rates, the P& I portion of newly financed mortgage payments was lowered, and housing affordability--or, the ratio of mortgage payments to income--rose to a high level. Housing affordability encouraged first time home buying, second home buying, and relocation to larger and more luxurious homes, and, so, helped to sustain aggregate demand during the recession.
Unfortunately, high housing affordability sparked something of a speculative bubble in housing. Some people were attracted into speculating in residential real estate by the "greater fool" theory of investing. A cool and calculating speculator buys low and sells high. But, during a speculative bubble, foolish speculators buy high in order to sell higher on the belief that there is a "greater fool" out there.
According to the Housing Affordability Index of the National Association of Realtors, housing affordability has come back down, from about 130 in 2003, when the Fed was pumping up the money supply, to about 100 in 2006. Along with this fall in housing affordability, home prices have softened, and time to sell has stretched out. In addition, housing starts have nose-dived.
What do these gyrations in the housing market mean? With regard to anybody's decision to buy or sell a home, or the kind of mortgage to use in order to finance a home purchase, my advice is always to make such decisions based on your long-term needs and preferences, not on the basis of speculating on the future course of housing prices and interest rates. But, having said this, I would say that it's a good time to buy. I don't see the bottom falling out of the real estate market, just a working-through of the excess inventory that was built-up during the housing bubble. *
"The American left has long deplored Bush's rhetorical reliance on such vulgar conceits as 'good' and 'evil.' But it seems even 'victory' is a problematic concept, and right now the momentum is all for defeat of one kind or another." --Mark Steyn