Inflation Fears and Housing
The headline figures on two widely followed U.S. economic reports released Oct. 18 seemed to indicate upbeat news for September: A sharper-than-expected drop in the consumer price index (CPI) and an upside surprise for housing starts. But a closer look at both releases suggests that year-over-year inflation trends remain a concern—and will continue to command the attention of Federal Reserve policymakers in the run-up to the Oct. 24–25 Federal Open Market Committee (FOMC) meeting—and that the housing market is still characterized by weakness.
Here is Action Economics' view of each report:
Consumer Price Index
The September overall CPI dropped 0.5% (below economists' median forecast of a 0.3% decline), while the core index, which excludes food and energy prices, rose 0.2% (median 0.2%).
No surprise that the decline in the overall figure was led by energy prices: The so-called energy aggregate dropped 7.2%, led by a 13.5% fall in gasoline prices. The huge energy drop is consistent with the bigger-than-expected energy price declines in the September trade price and producer price index reports and the surprisingly large drop in gasoline sales in the retail sales report.
But the core figure told a different story. Food prices rose 0.4%. The shelter component, which carries a large weight in the index, rose 0.3%, which marks six of the last seven months that this component has risen by 0.3% to 0.4%. Apparel prices rose 0.6% on top of the 0.9% gain in August. The monthly gain for the core index left the year-over-year gain at 2.9%, up from the August rate of 2.8%, which marks the highest rate since February, 1996. This measure is showing little sign of abating.
Note that if we see a 0.2% headline CPI gain in October, the year-over-year increase should moderate further to a likely near-term trough of 2.0%, as the easy comparisons come to an end. After that, we expect headline year-over-year CPI gains to return to the 3% area as we reach the end of the year.
It's the core that's important for the Fed, however, and here the uptick to the 2.9% year-over-year figure for September will be followed by the same heightened gain in October if the monthly gain is again 0.2%. The uptrend in core inflation survived the hefty freefall in gasoline and other commodity prices on the month. We think the September core figures suggest that the FOMC will remain concerned about current inflation trends at its Oct. 24–25 meeting despite the energy price correction. We expect that Ben Bernanke & Co. will leave rates unchanged at the October meeting.
September housing starts rebounded 5.9% to a 1.77-million-unit annual pace—well above the median forecast of 1.64 million. The starts gain marked the first increase in four months and the second increase in the last eight months.
The pop in housing starts joined the chorus of other housing indicators that show a bounce after the hit to the sector in July and August, like the MBA purchase index, yesterday's National Association of Home Builders' (NAHB) data, construction material purchase data from retail sales, and construction employment. Looking at the components of the report, single-family starts increased 4.3%, while the more volatile multifamily component jumped 12.7%.
Regionally, starts strength was paced by a 14% surge in the South, while the Midwest increased 3.4% from a particularly lean August level. The strength in the South and bounce in the Midwest was partially offset by a 2.2% decline in the West and a hefty 14% drop in the Northeast.
In contrast to the strength in starts, permits dropped 6.3% to a 1.619-million-unit annual pace. Permits have now fallen for eight straight months, and the current level is the lowest since October, 2001. The drop in permits was troublesome, and it suggests that the starts figures will linger at lean levels as we enter the fourth quarter, even if the construction sector overall continues to see growth driven by the nonresidential and public sectors and the multifamily and improvement segments of the residential sector.
The data are consistent with a continued large drag from residential construction in third-quarter GDP, where we expect decline of 22% following the 11% drop in the second quarter. Residential construction will be a drag on overall GDP growth for four straight quarters through the third quarter, despite a boost from post-hurricane rebuilding. This will mark the worst four-quarter performance since the 1990–1991 recession. The decline we expect in the third quarter will mark the largest decline since the first quarter of 1991. We will assume a 0.1% drop in September construction spending, due to the weakness in the units under construction series.
It's unclear where the bottom will be in the housing market correction to the frothy performance over the last three years, though the bounce in the MBA purchase data in September and the small rise in the NAHB index in October reported Oct. 17 is encouraging.