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The Flower Has Not Wilted Sufficiently to Abort Recovery

Irwin M. Stelzer

Little ado about not very much. Markets yawned when the government revised its initial estimate of economic growth in the first quarter from a slight positive, +0.1 percent, to a non-trivial negative of -1.0 percent. There are several reasons that the first shrinkage of the economy in three years did not deter investors from driving share prices to record levels, defying the old injunction to “sell in May and go away.”

First, economic activity in the first quarter of the year was adversely affected by the refusal of the earth to warm: cold and snow kept consumers home, disrupted supply chains and forced workers to miss work. The White House was quick to point out that starting in December of last year key economic indicators dipped in response to the “disruptive effect” of “severe weather.”

Second, and more important, most observers followed the sensible rule-when a number seems to be an aberration, disaggregate. The picture that process produces is not exactly one of unrelieved gloom. The main driver of the recorded shrinkage in the economy was a revision in the estimate of investment in inventory, which was originally pegged at -0.6 percentage point. The bean-counters’ final look boosted that volatile figure to -1.6 percentage point. Other components moved down a bit (a revised estimate of import growth being the most important), but the reversal of previous inventory build-ups was the main culprit.

Third, Q1 shrinkage is the gloomy view in the rear view mirror, while the forward view through the windshield has actually turned brighter. Because inventories are lower than originally thought, companies have less merchandise in their warehouses and on their shelves, meaning that they will have to produce more to meet demand than forecasters originally anticipated. Goldman Sachs’ economists decided that lower inventory levels in the first quarter mean higher levels of economic activity in the current quarter, and revised their Q2 growth estimate upward by 0.2 percentage points to 3.9%, and many analysts and investors are expecting a strong second half to follow a good second quarter. Chris Williamson, Markit’s chief economist says, “current indicators suggest this [1Q decline] was merely a temporary setback in an otherwise ongoing robust recovery, pointing to a strong rebound in the second quarter…. [and] to the strongest expansion of business activity in over four years in May…. Manufacturers enjoyed the largest monthly increase in production since February 2011 alongside a service sector that was growing at the fastest pace since March 2012….” And the index of economic activity in the Chicago area shot up in May to its highest level in three years.

This uptick in the economy in recent months is reflected in the Conference Board’s consumer survey, which showed that consumers’ assessment of both the present situation and the future outlook improved slightly in May. So did the portion of survey respondents reporting jobs plentiful vs. hard to get. All in all, consumer confidence is close to the post-recession high it reached earlier this year.

Whether that confidence will be reflected in the housing market, which after the jobs market (report due this coming Friday) is the one on which the Federal Reserve Board’s monetary policy team is most focused, remains to be seen. If the Fed’s forecast of accelerating growth is to prove correct, which would be refreshing since the Fed has consistently over-guessed future growth one-year out by some 1.6 percentage points, according to the Lindsey Group, the housing sector will have to take the, or least a laboring oar. It is difficult to tell from press reports whether the sector is up to the job. On the same day the New York Times led its report with “Home Resales Rise, but the Pace Lags,” while the Wall Street Journal told its readers, “Housing Recovery Gains Steam.”

Here are the facts. The good news is that sales of existing homes (90 percent of all sales) in April rose 1.3 percent from March, the first monthly increase this year, and of new homes by 6.4 percent; the bad news is that existing home sales were 6.8 percent below April of last year, and new home sales were 4.2 percent below year-earlier levels. The good news is that prices have continued to advance, by 5.2 percent in April; the bad news is that the increase was the lowest in two years, which may of course turn out to be good news after all if it makes home-buying more affordable for more people. The good news is that interest rates on conventional 30-year mortgages have fallen in seven of the last eight weeks, to 4.25 percent from 4.69 percent at the end of last year, according to Bankrate Inc.; the bad news is that rates are significantly above the affordability-enhancing 3.5 percent level reached a year ago. In short, sales and prices are better than in March, but not as “hot” as a year ago.

The worse news is that first-time buyers are having difficulty getting credit as nervous banks keep credit-quality standards extraordinarily tight, to the consternation of politicians who want standards lowered so that income-constrained buyers can realize the dream of home ownership. No surprise that politicians, who only a few years ago criticized bankers for easy-handed lending, and don’t have any of their own “skin in the game,” should worry less about consumers’ ability to meet their mortgage obligations than bankers who seem to have learned something from the wave of foreclosures that followed the popping of the last housing bubble. Throw in the fact that almost 10 million homeowners, some 20 percent of the U.S. total, are “under water”-their homes are worth less than their mortgages-and another 10 million have very little equity in their homes, and it is easy to see why it is not only first-time buyers but potential upgraders who are frozen out of the low-end of the housing market. On the high end, in cities such as San Francisco and New York, prices have appreciated so much that renting has become an attractive alternative to buying. All of which might explain why pending home sales-deals signed-fell in April by 9.2 percent compared with a year earlier, to the lowest level since last June. The higher-priced end of the market seems to be doing better, as builders Toll Brothers, which specializes in that segment, is reporting robust sales and an ability to obtain higher prices for its homes.

The bloom may be off the housing rose, but the flower has not wilted sufficiently to abort the recovery. With the inflation rate having doubled to the 2 percent Fed target, should the predicted increase in economic and job growth occur, chair Janet Yellen and her doves will find it more difficult to ignore their hawkish colleagues. But not impossible.

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