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State of the
Economy
4th
Quarter 2005
Introduction
After showing signs of remarkable resilience
despite the devastating effects of Hurricanes
Katrina and Rita in the Gulf states during the
third quarter of 2005, with real gross domestic
product (GDP) increasing by 4.1%, economic
activity slowed considerably during the fourth
quarter, increasing by a paltry 1.1%. This
significantly weaker growth follows a 3.3%
increase in GDP during the second quarter and a
3.8% increase during the first quarter of 2005.
Though economic activity increased at a
favorable rate in the third quarter, the
weakness in the fourth quarter would suggest
that the hurricanes in the third quarter had a
more detrimental economic impact than originally
anticipated by many forecasters. The apparent
resilience of the U.S. economy in light of
adverse exogenous shocks stemming from natural
disasters and the resulting spike in energy
prices during the third quarter was likely an
optimistic expectation perpetuated by skewed
economic data for the third quarter that was
boosted by firm economic activity prior to the
hurricanes in September. However, real GDP for
the full year 2005 still grew at an annual rate
of 3.5%, boosted by the strength of economic
activity during the first three quarters of the
year. The 1.1% increase during the fourth
quarter of 2005 is lower than the 3.3% increase
during the same period of 2004.
With the lingering impact of the hurricanes
continuing to manifest and the likelihood that
the reconstruction of the affected areas will
significantly boost economic activity now a low
probability event, conditions that would tend to
suggest further economic weakness in the coming
quarters now exist. To be sure, the economy in
2006 is likely to slow, with growth advancing at
a tempered rate comparable to that of the fourth
quarter, due to a number of adverse conditions
that may restrain demand such as continued high
energy costs and rising interest rates, which
are likely to significantly restrain consumer
spending.
Gross Domestic Product
Advance
estimates
released by the Bureau of Economic Analysis
(BEA) indicate that real GDP increased at an
annual rate of 1.1% in the fourth quarter as
compared to a revised rate of 4.1% in the third
quarter and a 3.3% rate in the second quarter of
2005. This weak increase in real GDP is the
slowest rate of growth since the first quarter
of 2003 when real GDP increased at a rate 1.7%
and the fourth quarter of 2002 when real GDP
increased at a rate of 0.2%. Economic growth
during the fourth quarter was lower, once again,
than the consensus forecast of 3.2% (revised
downward from 3.6% anticipated when surveyed
during the third quarter) annual growth in real
GDP anticipated by fifty-one forecasters
surveyed by the Federal Reserve Bank of
Philadelphia.
The third quarter growth in real GDP was
slightly higher on a revised basis at 4.1% at an
annual rate as compared to earlier estimates of
3.8% growth
For 2005, real GDP increased at an annual rate
of 3.5% as compared to an increase of 4.2% in
2004 and an increase of 2.7% in 2003.
Real personal consumption expenditures, which
accounts for about two-thirds of economic
activity, increased by 1.1% in the fourth
quarter as compared to a 4.1% increase in the
third quarter, a 3.4% increase during the second
quarter and a 3.5% increase in the first quarter
at a seasonally adjusted annual rate. Purchases
of durable goods, which surged by 9.3% during
the third quarter following a robust 7.9%
increase in the second quarter and a 2.6%
increase in the first quarter, decreased by
17.5%. This surge in purchases of durable goods
was due largely to a 13.8% decrease in
expenditure on motor vehicles and parts, likely
due to the gradual withdrawal of numerous
incentives offered to the general public by the
major automakers that had been quite successful
during the second and third quarters. Purchases
of furniture and household equipment increased
by roughly 3%, helping to offset some of the
negative impact from the decline in expenditures
on motor vehicles and parts. Data from the
Federal Reserve Beige Book released November 30,
2005 and January 18, 2006 indicated that almost
all of the Federal Reserve Districts noted
declines in motor vehicle sales during the
fourth quarter with a continuing trend towards
more fuel efficient vehicles in light of the
elevated energy prices. Demand for domestic
automobiles was noticeably less than that for
foreign brands.
Personal consumption expenditures on nondurable
goods increased by 5.1% during the fourth
quarter, higher than the 3.5% increase in the
third quarter and the 3.6% in the second
quarter. Retail sales, which had exhibited
modest strength during the third quarter,
experienced generally mixed results during the
third quarter. Food, luxury items, and
electronics were particularly strong sellers
during the fourth quarter holiday season, which
could be characterized as favorable with all but
one of the Federal Reserve Districts (Cleveland)
reporting increased retail sales during the
quarter on a year-over-year basis.
Real nonresidential fixed investment, which
increased by 8.5% in the third quarter and 8.8%
in the second quarter, increased at a more
tempered rate of 2.8% in the fourth quarter.
This rate of growth is lower than the 5.7%
increase in the first quarter as well.
Equipment and software investment activity,
which increased by 10.9% in the second quarter
and by 10.6% in the third quarter, showed
weakness as well, increasing by only 3.5%.
Following an increase of $58.2 billion in the
first quarter, private businesses drew down $1.7
billion in inventories during the second quarter
and an additional $13.3 billion in the third
quarter. For the fourth quarter, however,
private businesses increased inventories by
$25.7 billion, adding 1.45% to the fourth
quarter change in real GDP. The decrease in
private business inventories subtracted 0.43%
from GDP for the third quarter as compared to
subtracting 2.14% from the second quarter and
adding 0.29% to the first quarter change in real
GDP. This increase in inventories suggests
that businesses had allowed built-up inventory
stocks to be drawn down during the second and
third quarters. Given this drawdown and the
anticipated increased demand during the fourth
quarter holiday season, businesses likely
increased production during the late third
quarter and early fourth quarter in order to
maintain adequate supplies going into the
holidays which were expected to experience
favorable demand despite continued high energy
prices. As a result of this increased
production intended to balance supply with
demand expectations, production could be
expected to taper during the first quarter of
2006 in order for businesses to draw down the
increased inventories.
Real residential fixed investment increased by
3.5% in the fourth quarter following a 7.3%
increase in the third quarter and a 10.8%
increase in the second quarter. This more
tempered growth comes at a time of noticeable
slowing in real estate activity as speculation
over the existence of a real estate bubble has
mounted. This comes in the wake of strong
growth that has been evident for nearly a year
as investors and consumers have sought safe and
better returns in the real estate markets. This
tempered increase in real residential fixed
investment could be the result of adverse
impacts arising from removal of accommodative
monetary policy at a measured pace by the
Federal Reserve and the subsequent increase in
mortgage rates.
Data on new residential construction from the
U.S. Census Bureau and U.S. Department of
Housing and Urban Development indicated that
activity cooled noticeably in the fourth
quarter. Privately-owned housing units
authorized by building permits, which ended 2004
at 2,069,000 and ended the third quarter at
2,219,000, fell throughout the fourth quarter to
2,103,000 in October, 2,163,000 in November and
to 2,068,000 at the end of the year. For the
fourth quarter, new privately-owned housing
units authorized by building permits increased
slightly on a year-over-year basis at a rate
0.5%. In November, new privately-owned housing
units authorized by building permits increased
by roughly 3.3% on a year-over-year basis then
decreased by 0.6% on a year-over-year basis in
December.
Privately-owned housing starts, which ended the
third quarter at 2,160,000, also decreased
throughout the fourth quarter to 2,051,000 in
October, 2,121,000 in November, and to 1,933,000
in December. On a year-over-year basis,
privately-owned housing starts decreased 0.5% in
October, increased 17.4% in November, and
decreased by 5.7% in December. For September,
housing starts increased to 2,160,000 or by
roughly 13% on a year-over-year basis.
Housing starts in the fourth quarter decreased
from the third quarter levels and were at the
lowest levels of the year. This may foreshadow
the beginning of a period of less robust growth
in the real estate markets and may support other
data that indicates as such. However, as the
U.S. Department of Commerce/U.S. Census Bureau
and the U.S. Department of Housing and Urban
Development state in the new residential
construction press releases:
In interpreting changes in the statistics in
this release, note that month-to-month changes
in seasonally adjusted statistics often show
movements which may be irregular. It may take 4
months to establish an underlying trend for
building permit authorizations, 6 months for
total starts, and 6 months for total
completions.
At this point, it is still
too early to tell if the flattening in housing
starts is the start of a cooling in the robust
residential real estate market or merely a
statistical aberration. Data from the National
Association of Realtors (NAR) seem to confirm
the fourth quarter slowdown in real estate
activity. After homes changed hands at the
fastest pace in the second and third quarters
since the 1970s, existing home sales fell 5.7%
to 6,600,000 units on a seasonally adjusted
annualized basis in December. On a
year-over-year basis, sales of existing homes
decreased 3.1% in December. For the year,
however, existing home sales increased 4.2% in
2005 as compared to 2004 to 7,072,000, the fifth
consecutive annual record since the NAR began
tracking sales in 1968. The national median
price of all housing types increased 10.5% in
December on a year-over-year basis to $211,000.
For the full year, the median price was
$208,700, an increase of 12.7% from the $185,200
level in 2004. For single family homes, sales
declined 6.8% in December to a seasonally
adjusted annual rate of 5,720,000 from
November. On a year-over-year basis, sales of
existing single family homes declined 4.2% in
December. For the full year, however, single
family home sales increased 3.6% as compared to
2004. The median price of existing single
family homes was $209,300 in December, an
increase of 10.8% over the December 2004 median
price. For the year, the median single family
home price increased 12.6% to $207,300.
These rapidly increasing
price figures for existing home sales have, in
part, fueled debate that the U.S. real estate
market is experiencing an unsustainable bubble
in asset prices. Indeed, the Mortgage Bankers
Association indicated that more than 60% of the
dollar value of new mortgage loans were
adjustable-rate or interest-only during the
second half of 2004. This could create
significant problems for borrowers as rates
begin to increase and the adjustable-rate
mortgages are reset, forcing many buyers and
investors out of the market. Indeed, even Alan
Greenspan voiced concerns with the activity in
the U.S. real estate markets, warning in
testimony to the Joint Economic Committee of the
Congress on June 9, 2005:
That said, there can be little doubt that
exceptionally low interest rates on ten-year
Treasury notes, and hence on home mortgages,
have been a major factor in the recent surge of
homebuilding and home turnover, and especially
in the steep climb in home prices. Although a
"bubble" in home prices for the nation as a
whole does not appear likely, there do appear to
be, at a minimum, signs of froth in some local
markets where home prices seem to have risen to
unsustainable levels…
The apparent froth in housing markets may have
spilled over into mortgage markets. The dramatic
increase in the prevalence of interest-only
loans, as well as the introduction of other
relatively exotic forms of adjustable-rate
mortgages, are developments of particular
concern. To be sure, these financing vehicles
have their appropriate uses. But to the extent
that some households may be employing these
instruments to purchase a home that would
otherwise be unaffordable, their use is
beginning to add to the pressures in the
marketplace.
In remarks to the American
Bankers Association Annual Convention in
September, Alan Greenspan commented the
following:
Over the past decade, the market value of the
stock of owner-occupied homes has risen annually
by approximately 9 percent on average, from $8
trillion at the end of 1995 to $18 trillion at
the end of June this year. Home mortgage debt
linked to these structures has risen at a
somewhat faster rate…
…In the United States, signs of froth have
clearly emerged in some local markets where home
prices seem to have risen to unsustainable
levels. It is still too early to judge whether
the froth will become evident on a widening
geographic scale, or whether recent indications
of some easing of speculative pressures signal
the onset of a moderating trend.
Speculation in homes is also largely local,
especially for owner-occupied residences. For
homeowners to realize accumulated capital gains
on a residence—a precondition of a speculative
market—they must move…Transactions in second
homes, of course, are not restrained to the same
degree as sales of primary residences—an
individual can sell without having to move.
This suggests that speculative activity may have
had a greater role in generating the recent
price increases than it customarily has had in
the past.
The apparent froth in housing markets may have
spilled over into mortgage markets. The
dramatic increase in the prevalence of
interest-only loans, as well as the introduction
of other, more exotic forms of adjustable-rate
mortgages, are developments that bear close
scrutiny. To be sure, these financing vehicles
have their appropriate uses. But to the extent
that some households may be employing these
instruments to purchase a home that would
otherwise be unaffordable, their use is adding
to pressures in the marketplace.
The Federal Reserve Beige Book from March 9,
2005 and April 20, 2005 indicates that
residential real estate activity throughout most
of the twelve Districts remained strong during
the first quarter with many Districts noting
increased activity late in the quarter. The
Beige Book released on June 15, 2005 and July
27, 2005 indicates that the real estate markets
remained positive, though signs of cooling were
noted in some areas. Several Districts that had
experienced noticeable increases in home prices
earlier in the year indicated that price
appreciation had begun to normalize from
frenzied levels. In addition, several Districts
noticed that housing activity had decelerated
from earlier aggressive levels. The strength in
the residential real estate markets in the first
half of 2005 continued a favorable trend that
had characterized real estate throughout the
twelve Districts for much of the last year.
According to the Beige Book released on
September 7, 2005, residential real estate
activity remained strong throughout the
Districts. However, many Districts noted signs
of cooling since the previous Beige Book.
Several Districts also noted that, although real
estate activity remained strong, the pace of
construction was lower than the previous year.
The Beige Book released on October 19, 2005 also
indicated that many Districts noticed signs of
slowing demand for housing. In addition, many
Districts reported that homes sales were taking
longer and that the inventory of homes for sale
was increasing. Overall, these signs indicate
that the cooling of the real estate markets
which had manifested throughout the first half
of the year continued into the third quarter.
The Beige Book released on November 30, 2005 and
January 18, 2006 indicated moderation in
residential real estate activity in most of the
twelve Districts during the fourth quarter.
Homes sales reportedly slowed in many Districts,
with the inventory of homes available for sale
increasing as well as the amount of time homes
were on the market, and price appreciation
experienced a more muted rate. The data
included in the Beige Book seems to confirm
signs of cooling that had begun to manifest in
the third quarter.
After ending the year at
5.81%, thirty-year conventional mortgages
according to Freddie Mac
declined during the first quarter from 5.77% to
a low of 5.57% in February before climbing to
6.04% by the end of March. During the second
quarter, thirty-year conventional fixed rate
mortgage rates fell steadily during the quarter,
ending June at 5.53%--a low for the year.
During the third quarter, however, thirty-year
conventional fixed rate mortgages steadily
increased to 5.89% by early August before
retrenching slightly to 5.71% by early September
and increasing once again to end the quarter at
roughly 5.91%. During the fourth quarter,
thirty-year conventional mortgage rates
increased to a high of roughly 6.33% in November
before ending the year at roughly 6.27%.
Fifteen-year mortgages experienced a similar
pattern, rising from 5.21% at the first of the
year to 5.58% at the end of the first quarter
then falling during the second quarter to
5.12%. For the third quarter, fifteen-year
mortgages increased to 5.47% by early August,
retrenched to 5.30% by early September, and
increased to 5.48% by the end of the quarter.
For the fourth quarter, fifteen-year rates
increased to 5.86% in November and ended the
year at roughly 5.82%.
The continued low mortgage rates coincide with
U.S. Treasury yields on the 10-year note, which
increased only slightly from 4.23% at the
beginning of January to 4.50% by the end of
March before declining to roughly 3.94% by the
end of June. During the third quarter, the
yield on the 10-year Treasury note increased to
roughly 4.34%. For the fourth quarter, the
yield on the 10-year Treasury note rose to a
quarterly high of 4.66% by early November before
falling to end the quarter at 4.37%, virtually
unchanged from the level at the beginning of the
quarter. By the end of the quarter, the yield
curve had inverted briefly with the two-year
yield rising above the yield on the ten-year
note. Though this inversion was reversed in
early January, the yield curve inverted once
again by the middle of the month.
This yield curve inversion results from an
increase in short-term rates associated with the
Federal Reserve’s removal of accommodative
monetary policy at a measured pace and market
expectations of slower economic growth in the
future. Since the 1970s, every U.S. recession
has been preceded by an inverted yield curve.
However, not all inverted yield curves have
historically been followed by a recession. As a
result of these developments, there is a growing
number of economists, business leaders, and
analysts who now believe that the current
economic conditions may be a precursor to a
recession.
Continued interest rate increases may contribute
to a slowing of real estate activity and
residential construction in the coming
quarters. Such increases may have an unwelcome,
adverse impact upon speculators in the real
estate markets and investors who have committed
to degrees of leverage which they may not be
able to service as rates increase. This could
have the effect of removing some of the “froth”
in certain local real estate markets.
Following increases of 7.5% in the first
quarter, 10.7% in the second quarter, and 2.5%
in the third quarter, real exports of goods and
services for the fourth quarter increased 2.4%.
Imports, a subtraction from GDP, increased 9.1%
in the fourth quarter following a 2.4% increase
during the third quarter. Imports decreased
0.3% during the second quarter and increased
7.4% during the first quarter.
At the end of the fourth
quarter of 2004, the dollar/sterling ($/£)
exchange rate stood at roughly $1.92. The
dollar strengthened against the pound sterling
during the first quarter to end the period at
$1.89. The dollar continued to gain ground
against the pound sterling during the second
quarter, rising gradually to $1.82 by the end of
the quarter. During the third quarter, the
dollar made slight gains against the pound
sterling to $1.72 by the end of July before
weakening to $1.85 by early September. By the
end of the quarter, the dollar had once again
gained against the pound sterling to $1.75.
During the fourth quarter, the dollar weakened
to $1.79 against the pound sterling by early
November before gaining to end the quarter at
$1.75, unchanged from the beginning of the
fourth quarter. For the year, the dollar
strengthened from $1.92 to $1.75 against the
pound sterling. The dollar/euro ($/ˆ) exchange
rate was $1.35 at the end of the fourth quarter
of 2004 and $1.30 at the end of the first
quarter of 2005. During the second quarter, the
dollar strengthened to $1.20 against the euro.
The dollar ended the third quarter at $1.20
against the euro before strengthening to $1.16
by mid-November. The dollar ended the fourth
quarter unchanged at $1.20 against the euro,
stronger than the $1.35 rate at the end of
2004. At the end of the fourth quarter of 2004,
the yen/dollar (¥/$) exchange rate stood at
¥104. By the end of the first quarter the
dollar stood at ¥107. The dollar continued to
gain strength against the yen during the second
quarter, ending the period at ¥110.
During the third quarter, the dollar made
further gains against the yen, rising to ¥113 by
the end of the quarter. By the end of the year,
the dollar had made further gains against the
yen, rising to a high of ¥121 by early December
before retrenching to ¥116 by year end.
The strengthening of the
dollar during the year may stem from a variety
of issues such as continued weak economic data
in the euro zone, continued increases in
interest rates as part of the Federal Reserve’s
removal of accommodative monetary policy, and
low inflation expectations in the United
States. These factors may have driven the
dollar higher against other foreign currencies,
despite continued higher federal budget deficits
in the United States. In addition, Middle
Eastern oil exporters began holding a higher
proportion of OPEC deposits in dollars—69.5% as
compared to 61.5% in the prior year.
Subsequently, OPEC’s share deposits in euros
fell from 24% to 16%, based on estimates from
the Bank for International Settlements. This
recycling of petrodollars has likely been the
cause of the gains the dollar has made against
other currencies, particularly as interest rate
increases in the United States increased the
return on deposits relative to those in the
European Union.
However, with the European Central Bank having
instituted its own cycle of rate increases in
December, oil exporters may shift deposits to
euros should the interest rate differential
narrow between the two currencies.
Real federal government consumption expenditures
remained steady in the first half of 2005,
increasing by 2.4% in the first and second
quarters. During the third quarter, real
federal government consumption expenditures
increased by 7.4%. For the fourth quarter, real
federal government consumption expenditures
decreased by 7.0%. This decrease in the rate of
federal government consumption expenditures was
the result of decreased national defense
spending. After increasing 3.0%, 3.6% and 10.0%
in the first, second, and third quarters,
respectively, national defense spending
decreased 13.1% in the fourth quarter.
Nondefense spending, which increased by only
1.1% in the first quarter, decreased by 0.2%
during the second quarter and increased by 2.4%
during the third quarter. For the fourth
quarter, nondefense spending increased 6.9%.
The Federal Reserve
The Federal Reserve
continued to tighten monetary policy during the
fourth quarter of 2005. By the end of 2004, the
Federal Open Market Committee (FOMC) had
increased the federal funds rate to 2 ¼%.
At its meeting on February 2, 2005, the FOMC
agreed a twenty-five basis point increase in the
target for the federal funds rate to 2 ½%.
The FOMC once again stated that it believed
monetary policy remained accommodative and
continued to provide ongoing support to economic
activity.
At its meeting on March
22, 2005, the FOMC agreed another twenty-five
basis point increase in the target for the
federal funds rate to 2 ¾%.
The FOMC continued to believe that the risks to
sustainable growth and price stability were
equal for the coming quarters. The Committee,
however, indicated that:
Though longer-term inflation expectations remain
well contained, pressures on inflation have
picked up in recent months and pricing power is
more evident. The rise in energy prices,
however, has not notably fed through to core
consumer prices.
The FOMC agreed a
twenty-five basis point increase in the federal
funds rate at each of its meetings on May 3,
2005 and June 30, 2005,
bringing the federal funds rate to 3% and 3 ¼%.
The Committee continued to believe that monetary
policy was accommodative and, along with
productivity gains, provided ongoing support to
economic activity. Furthermore, the Committee
indicated the following:
Although energy prices have risen further, the
expansion remains firm and labor market
conditions continue to improve gradually.
Pressures on inflation have stayed elevated, but
longer-term inflation expectations remain well
contained.
In the
Monetary Policy Report to the Congress,
released in July, the Federal Reserve
policymakers expressed optimism for continued
economic expansion at a moderate pace in 2005
with stable core inflationary pressures. The
Federal Reserve Board of Governors and Federal
Reserve Bank Presidents project that real GDP
will increase by 3%-3 ¾% in 2005 (as compared to
previous forecasts of 3 ½%-4%) as compared to
real GDP growth of 3.7% in 2004.
Real GDP is expected to increase by 3 ¼%-3 ¾% in
2006; this forecast is unchanged from earlier
forecasts. The personal consumption
expenditures chain-type price index (the Federal
Reserve’s preferred measure of inflation)
excluding food and energy is expected to range
from 1 ½%-2 ¼% in 2005 (as compared to earlier
forecasts of 1 ½%-2%), higher than the 1.6%
increase in 2004. For 2006, the PCE index
excluding food and energy is expected to range
from 1 ½%-2 ½%; earlier forecasts suggested core
PCE increases in 2006 of 1 ½%-2%. The civilian
unemployment rate is anticipated to range from
5%-5 ¼% (compared to earlier forecasts of 5%-5
½%) in 2005, against 5.4% for 2004, and roughly
5% in 2006 (earlier forecasts were for 5%-5
¼%).
The FOMC agreed
a twenty-five basis point increase in the
federal funds rate at each of its meetings on
August 9, 2005 and September 20, 2005,
bringing the federal funds rate to 3 ½% and 3
¾%. In its press release following the August
meeting, the FOMC indicated that monetary policy
remained accommodative and that aggregate
spending appeared to have strengthened despite
high energy prices. In addition, there were
continued improvements in the labor markets, and
core inflation remained relatively low, though
there were upward pressures on inflation. In
the September 20, 2005 press release, the FOMC
discussed the impact of Hurricane Katrina on its
economic outlook:
Output appeared poised to continue growing at a
good pace before the tragic toll of Hurricane
Katrina. The widespread devastation in the Gulf
region, the associated dislocation of economic
activity, and the boost to energy prices imply
that spending, production, and employment will
be set back in the near term. In addition to
elevating premiums for some energy products, the
disruption to the production and refining
infrastructure may add to energy price
volatility.
While these unfortunate developments have
increased uncertainty about near-term economic
performance, it is the Committee’s view that
they do not pose a more persistent threat.
Rather, monetary policy accommodation, coupled
with robust underlying growth in productivity,
is providing ongoing support to economic
activity. Higher energy and other costs have
the potential to add to inflation pressures.
However, core inflation has been relatively low
in recent months and longer-term inflation
expectations remain contained.
The FOMC continued to believe that
monetary policy accommodation could be removed
at a measured pace and that the risks to the
attainment of sustainable growth and price
stability remained equal.
The FOMC raised
the federal funds rate by an additional
twenty-five basis points at the November 1, 2005
meeting and again at the December 13, 2005
meeting. As a result, the federal funds rate
ended the year at 4 ¼%.
In its press release following the December 13,
2005 meeting, the FOMC indicated that further
measured policy firming would likely be needed
to balance sustainable economic growth and price
stability. However, the FOMC made the following
assessment:
Despite elevated energy prices and
hurricane-related disruptions, the expansion in
economic activity appears solid. Core inflation
has stayed relatively low in recent months and
longer-term inflation expectations remain
contained. Nevertheless, possible increases in
resource utilization as well as elevated energy
prices have the potential to add to inflation
pressures.
Though the FOMC initially anticipated that the
hurricanes in the third quarter would have
little economic impact, that assessment seems to
have been misguided given the significant
deceleration in economic growth during the
fourth quarter. This would tend to suggest that
the systemic impacts of the hurricanes, which
helped to boost energy prices higher from
already elevated levels, are likely to be felt
for quarters to come. In addition, inflation
pressures seem to have been mounting in the last
two quarters, placing the FOMC in a precarious
position of confronting higher inflation during
a period of slowing economic growth. Though the
engines of economic growth in America have not
shut down, they have certainly shown signs of
slowing under the burden of higher energy
prices, rising interest rates, mounting
inflationary pressures and the attending impacts
these factors have upon consumer sentiment and
consumption.
The Federal Reserve Beige
Books
released on November 30, 2005 and January 18,
2006 suggest modest economic expansion during
the fourth quarter throughout the twelve
Districts.
The Beige Book conclusions included the
following:
-
Retail sales were favorable during the
holiday season of the fourth quarter after
showing signs of weakness late in the third
quarter, most likely due to disruptions
following Hurricanes Katrina and Rita.
Retailers noted increased sales of gift
cards, resulting in expectations for
stronger sales in coming months as shoppers
redeem the gift cards and make additional,
concurrent purchases. Automobile sales were
characterized as declining or sluggish
across the nation, though sales of foreign
brands were particularly strong.
-
Manufacturing activity continued to expand
throughout the country. Construction and
defense and aerospace experienced noticeable
gains in many Districts. Declines in
activity were noticed once again in the
automobile industry.
-
Residential real estate activity, after
showing some signs of cooling during the
second quarter and firming again during the
third quarter, moderated during the last
quarter of the year. Some Districts noted
slowing home sales and price appreciation,
rising inventory levels, and longer selling
times of existing homes. Commercial real
estate activity continued to strengthen in
general during the third quarter. Office
vacancy rates fell in some Districts, and
demand for office space seemed to have
picked up in many markets. New commercial
construction activity was generally
anticipated to improve in 2006.
-
Labor markets continued to experience modest
gains throughout most of the Districts.
Some areas noted continued tight labor
markets, though wages has experienced only
modest increases. Skilled professionals
remained in short supply in many areas.
-
Unseasonably warm weather resulted in
favorable tourism activity during the fourth
quarter in many Districts. Many of the
previously hurricane affected areas noted
improvements, but a lack of snow hurt some
ski resorts.
Consumer Confidence
After ending
2004 at a level of 102.7, the Conference Board’s
Consumer Confidence Index
ended the first quarter of 2005 virtually
unchanged at 103. For the second quarter, the
Index increased to a three year high of 106.2
before falling to 87.5 by the end of the third
quarter—the lowest level in two years. In the
aftermath of Hurricanes Katrina and Rita, Lynn
Franco, Director of The Conference Board’s
Consumer Research Center, indicated the
following with respect to the consumer
confidence figures:
Hurricane Katrina, coupled with soaring gasoline
prices and a less optimistic job outlook, has
pushed consumer confidence to its lowest level
in nearly two years (81.7 in October 2003) and
created a degree of uncertainty and concern
about the short-term future. Historically,
shocks have had a short-term impact on consumer
confidence, especially on consumers’
expectation. Fuel prices remain high, though
they have retreated in recent days, and when
combined with a weaker job market outlook, will
likely curb both confidence and spending for the
short-run. As rebuilding efforts take hold and
job growth gains momentum, consumers’ confidence
should rebound and return to more positive
levels by year-end or early 2006.
During the fourth quarter, the
Consumer Confidence Index declined to 85.2 in
October, rose to 98.3 in November, and increased
further to 103.6 in December. In analyzing the
strong rebound in consumer confidence, Lynn
Franco indicated the following:
Consumer confidence continues to bounce back and
is now at its highest level since Hurricane
Katrina struck the Gulf Coast. The resiliency
of the economy, recent declines in prices at the
pump, and job growth have consumers feeling more
confident at year-end than they felt at the
start of 2005. Even though all of the
improvement over the past twelve months has been
in consumers’ assessment of current conditions,
and expectations remain below earlier levels,
consumers are confident that the economy will
continue to expand in 2006.
After ending 2004 at 100.7, the Expectations
Index declined to 93.7 by the end of the first
quarter and rebounded slightly to 96.4 by the
end of the second quarter. The decline in the
Expectations Index throughout the first half of
the year may be attributed to consumers’
anticipation of modest economic growth and
meager income gains due to continued elevated
energy prices. The upturn during the second
quarter may have been due to gains in the labor
markets and upward revisions to first quarter
economic activity that had initially shown signs
of softness. For the third quarter, the
Expectations Index declined dramatically to 71.7
for September. The severe dip in September is
likely the result of transitory factors stemming
from the psychological impact of Hurricane
Katrina. For the fourth quarter, the
Expectations Index fell to 70.1 in October, rose
to 88.4 in November and increased to 91.6 in
December. This rebound in the Expectations
Index likely stems from modest improvement in
consumer expectations regarding economic
performance in the wake of the hurricanes in the
third quarter.
Consumers’ outlook for the next six months eased
during the first quarter. In January, February,
and March, 22%, 17.9%, and 19.3%, respectively,
expected business conditions to improve in the
next six months. For April, this declined to
17.7% before rebounding in May to 19.2% and to
19.5% in June. For the third quarter, consumers
became increasingly pessimistic with 17.9%
expecting condition to improve in the next six
months in July, 18.7% in August, and only 15.3%
in September. During the fourth quarter, those
expecting conditions to improve during the next
six months improved from 14.1% in October to 19%
in November before retrenching to 18.1% in
December. Those expecting conditions to worsen
increased in March to 8.2% after holding steady
in January and February at 7.8%. Those
expecting conditions to worsen increased to 9.9%
in April before falling to 9.5% in May and to
9.0% in June. The readings for the third
quarter were similar—those anticipating business
conditions to worsen increased to 9.5% in July,
10% in August, and 19.8% in September. During
the fourth quarter, those expecting conditions
to worsen improved from 18.5% in October to
11.5% in November to only 9.2% in December.
Though the readings suggest that consumers had,
over the first half of the year, become
increasingly concerned about business conditions
going forward, their expectations seems to have
improved modestly during the second half.
Consumers’ concerns about business conditions in
the next six months were further negatively
impacted by the hurricanes in the third
quarter. As consumers appeared to have
considered the impact of the hurricanes to be a
transitory factor, consumer expectations
regarding the future business conditions
generally improved and may continue to improve
during the first quarter of 2006.
Consumers’ assessment of current
business conditions was mixed during the first
and second quarters. With 24.4% of respondents
characterizing current conditions as “good” in
December 2004, this figure improved to 26.3% in
March. By the end of the second and third
quarters, those characterizing current
conditions as “good” increased to 26.7% in June
and fell to 25.2% in September. For the fourth
quarter, 23.3% characterized conditions as
“good” in October, rising to 25.6% in November
and to 24.3% in December. As the end of the
first quarter, those characterizing conditions
as “bad” stood at 15.8% in March. For the
second and third quarters, 15.3% and 17.7%
characterized conditions as “bad,”
respectively. For the fourth quarter, 18.4%
characterized conditions as “bad” in October
with this figure decreasing to 17.9% in November
and 14.7% in December.
Again, the improvement in the fourth quarter may
be the result of consumers’ recognition of
transitory factors such as high energy prices,
the psychological impact of Hurricanes Katrina
and Rita, economic displacement created by the
hurricanes, etc. Though a jump in any one month
may be a temporary phenomenon rather than a
sustained shift in consumers’ expectations
regarding the economic outlook, the increased
optimism may indicate that consumers have yet to
recognize the actual long-term threats to
economic growth stemming from factors such as
the hurricanes, rising energy prices, increased
interest rates, etc. As consumers become more
cognizant of the risks to the economy, consumer
confidence may fall and prompt consumers to
restrain spending, which could have further
detrimental impacts upon economic growth during
2006.
The Business Sector
The moderate
gains in industrial production during the first
quarter continued during the second quarter of
2005 as a result of continued economic
strength. For the first quarter, industrial
production, as compiled by the Federal Reserve,
increased at an annual rate of 3.8% following an
increase of 4.5% in the fourth quarter of 2004.
For the second and third quarter, industrial
production increased 1.6% and 1.4% at an annual
rate,
following a trend of growth rates increasing at
a decreasing rate. For the fourth quarter,
industrial production increased at a stronger
annual rate of 3.8%. This more favorable
increase in industrial production is likely a
result of the addition to inventories that
businesses made during the fourth quarter in
order to replenish stocks drawn down during the
third quarter and in anticipation of robust
holiday demand for goods. For the full year
2005, industrial production increased 2.8% over
the 2004 level.
On a year-over-year basis, industrial production
increased by 3.9%, 3.5%, and 3.9% in January,
February, and March, respectively. During the
second quarter, industrial production increased
by 3.1%, 2.7%, and 3.9% in April, May, and June,
respectively, on a year-over-year basis. For
the third quarter, industrial production
increased by 3.0%, 3.1%, and 2.0% in July,
August, and September, respectively, on a
year-over-year basis. During the fourth
quarter, industrial production increased 1.9% in
October, 2.8% in November, and 2.8% in December
on a year-over-year basis.
Manufacturing production increased at an annual
rate of 4.5%, 1.3%, and 2.0% in the first three
quarters of 2005, respectively. For the fourth
quarter, however, manufacturing production
increased by 7.9%. This strength in
manufacturing is confirmed by anecdotal evidence
contained in The Beige Book releases from the
Federal Reserve during the fourth quarter which
indicated generally favorable manufacturing
gains throughout the twelve Districts.
Manufacturing production increased by 5.2%,
4.7%, and 4.1% on a year-over-year basis in
January, February, and March, respectively, and
by 3.5%, 3.4%, and 3.8% in April, May, and June,
respectively. In the third quarter,
manufacturing production increased 3.0%, 2.9%,
and 2.9% on a year-over-year basis in July,
August, and September, respectively. For the
fourth quarter, manufacturing production
increased 3.2% in October, 3.9% in November, and
3.8% in December on a year-over-year basis.
Durable goods production, which increased by
1.7% in the first quarter, declined at an annual
rate of 2.5% in the second quarter but surged by
10.8% in the third quarter, increased by 1.0% in
the fourth quarter. Nondurable goods
production, which increased by 1.0% in the third
quarter following a 3.1% increase in the second
quarter and a 2.7% increase in the first
quarter, declined in the fourth quarter by
1.1%. Defense and space equipment production
continued a robust production pattern,
increasing by 8.9% in the fourth quarter
compared with increases of 12%, 11.5%, and 5.8%
in the first three quarters of 2005. Following
a first quarter increase of 0.9%, construction
supplies increased by 4.1% in the second quarter
and by 4.7% in the third quarter before surging
by 14.2% in the fourth quarter. This gain in
construction supplies may be the result of
continue new housing activity and increases in
commercial construction.
On a quarterly basis, capacity utilization
increased in the fourth quarter of 2005 to 80.2%
as compared to 79.9% for the first and second
quarter and 79.8% for the third quarter.
Though capacity utilization increased slightly
during the fourth quarter, this level of 80.2%
remained 0.8% below the 1972 to 2004 average of
81%. However, the trend of increasing capacity
utilization coincides with the increased
activity in manufacturing activity evident
through a number of other figures and
resources. Manufacturing capacity utilization
increased throughout 2005, increasing from 78.7%
in the first quarter to 79.6% in the fourth
quarter. This follows a slight decline to 78.5%
in the second and third quarters. At 79.6%,
capacity utilization in the fourth quarter is
just shy of the 1972 to 2004 average of 79.8%.
The advance
monthly sales for retail trade and food services
in the fourth quarter released by the Department
of Commerce
continue to suggest modest economic activity.
In December, retail and food service sales
increased by approximately 0.7%
from November to $357.8 billion. This gain in
December follows a 0.8% increase in November and
a 0.3% increase in October’s figures. Total
retail sales increased by 0.7% in December from
the November level, 0.8% in November and 0.3% in
October.
On a year-over-year basis, monthly sales for
retail trade and food service increased 8.1% in
January, 7.8% in February, and 5.8% in March.
For the second quarter, monthly sales for retail
trade and food service increased 8.9% in April,
6.4% in May, and 9.6% in June on a
year-over-year basis. During the third quarter,
total retail sales and food service increased
10.4% in July on a year-over-year basis, 8.1% in
August, and 6.5% in September. In the fourth
quarter, total retail sales and food service
increased 6.0% in October, 6.8% in November, and
6.4% in December.
For the fourth quarter, advance monthly retail
and food service sales increased 0.6% from the
third quarter. On a year-over-year basis,
advance monthly sales for retail trade and food
services increased 6.3% in the fourth quarter.
For the first quarter, retail and food service
sales increased by 1.3% from the fourth quarter
and by 7.2% on a year-over-year basis. For the
second quarter, retail and food service sales
increased by 2.6% from the first quarter and by
8.4% from the second quarter a year ago. For
the third quarter, total retail and food service
sales increased by 1.6% from the second quarter
and by 8.3% from the same period a year ago.
After increasing 1.7% in the first quarter as
compared to the fourth quarter of 2004 and by
7.8% on a year-over-year basis, total sales
excluding motor vehicles and parts increased by
2.2% in the second quarter from the first
quarter and by 8.3% on a year-over-year basis.
For the third quarter, total sales excluding
motor vehicles and parts increased 2.3% as
compared to the second quarter and 9.1% on a
year-over-year basis. For the fourth quarter,
total sales excluding motor vehicles and parts
increased 1.8% from the third quarter level and
by 8.7% on a year-over-year basis. Sales of
motor vehicles and parts declined by 3.8% in the
fourth quarter as compared to the third quarter
and by 1.8% from the fourth quarter of 2004.
For the fourth quarter, total retail sales
increased 0.3% from the third quarter and by
6.2% on a year-over-year basis. This follows a
1.8% increase in the third quarter as compared
to the second quarter and an 8.5% increase on a
year-over-year basis from the third quarter
2004. Retail sales, which increased 1.3% in the
first quarter over the prior quarter and 7.2% on
a year-over-year basis, increased by 2.6% in the
second quarter as compared to the first and by
8.4% on a year-over-year basis.
Slower economic growth and consumer
spending during the first quarter resulted in a
build-up of private inventories during the first
quarter. These stocks, however, were largely
drawn down during the second and third
quarters. As a result, manufacturing activity
softened somewhat during the second quarter of
2005 but began to rebound during the third
quarter. This increase in manufacturing
activity continued at a favorable pace into the
fourth quarter as businesses added to
inventories in anticipation of a strong holiday
shopping season. It could be expected that
manufacturing activity may maintain a modest
pace in the first part of 2006 as businesses
adjust production to allow for the inventories
drawn down during the fourth quarter to be
replenished. However, with energy prices
expected to remain elevated and interest rates
continuing to rise, consumer confidence may be
dampened and prompt a retrenchment in
consumption expenditures. In addition,
deterioration in the robust level of real estate
activity and home price appreciation may further
dampen consumer confidence and prompt increased
saving by consumers. Overall, these factors
tend to suggest that the slowdown in economic
activity during the fourth quarter of 2005 may
continue to foster weaker economic conditions
into 2006.
Inflation
Following a 3.0%
increase in the consumer price index (CPI)
during the fourth quarter of 2004 at a
seasonally adjusted annual rate and increases of
4.3%, 1.9%, and 9.4% during the first, second,
and third quarters of 2005, respectively, the
CPI decreased by a compound annual rate of 1.6%
in the fourth quarter. The third quarter
increase in the CPI of 9.4% was roughly three
times higher than the 3.3% increase for all of
2004. The decline in the CPI for the fourth
quarter was likely a statistical aberration
stemming from declines in the energy index
during the fourth quarter. For 2005, the CPI
increased by 3.4%, roughly in line with the 3.3%
increase for 2004, but still higher than the
1.9% increase in 2003.
Following an increase of 0.1% in January, 0.4%
in February, and 0.6% in March on a seasonally
adjusted basis, the CPI increased by 0.5%,
-0.1%, and 0.0%, in April, May, and June,
respectively. In July, August, and September,
the CPI increased by 0.5%, 0.5%, and 1.2%,
respectively. For the fourth quarter, the CPI
increased by 0.2% in October and declined by
0.6% and 0.1% in November and December,
respectively. For the twelve months ending in
December, the CPI increased at an annual rate of
3.4% as compared to an annual rate of 4.7% for
the twelve months ending in September 2005.
For 2005, the energy index increased by 17.1% on
a seasonally adjusted annual basis, as compared
to a 16.6% increase for 2004. In the first and
second quarter, the energy index increased at
annual rates of 21.1% and 7.5%. For the third
quarter, the energy index increased by 122.1%,
inflated by the spike in energy prices following
Hurricanes Katrina and Rita. For the fourth
quarter, the energy index declined by 35.2%.
For the first half of the year, the energy index
increased by 14.1%; for the second half of the
year, the energy index increased by 20%. Food
prices during the year also increased, with the
food index advancing at an annual rate of 2.3%,
lower than the 2.7% annual rate for the
full-year 2004. On a quarterly basis, the food
index increased by 1.3% in the first quarter,
3.4% in the second, 1.9% in the third, and 3.0%
in the fourth quarter.
Removing the effects of food and energy, the
core CPI increased by 2.8% in the fourth quarter
as compared to 1.4% in the third quarter, 1.2%
in the second quarter, and 3.3% in the first
quarter. The core CPI advanced at a rate of
2.2% for both 2004 and 2005. For the first half
of 2005, the core CPI increased by 2.2%. For
the second half of the year, the core CPI
increased by 2.1%.
In addition to the CPI,
the price index for personal consumption
expenditures (PCE) from the BEA
rose by 2.6% in the fourth quarter as compared
to increases of 2.3%, 3.3%, and 3.7% in the
first, second, and third quarters,
respectively. On a year-over-year basis, the
PCE rose by 3.5%, 3.9%, 3.8%, and 3.0% in each
of the four quarters of 2005. For the year, the
price index for the PCE increased 2.8% as
compared to 2.6% in 2004. Excluding volatile
food and energy prices, the gross domestic
purchases price index rose by 2.5% for 2005 as
compared to an increase of 2.4% in 2004. The
PCE excluding food and energy prices increased
2.2%, 2.0%, 1.9%, and 1.9% in the first, second,
third, and fourth quarters of 2005,
respectively, on a year-over-year basis.
These figures, closely watched by the Federal
Reserve, continue to suggest that inflation has
picked up in recent months. This further
supports the FOMC’s decision to continue
removing monetary policy accommodation at a
measured pace. It does not appear that core
inflation accelerated at a more alarming rate in
2005 as compared to 2004, continuing a trend of
relative price stability once the effects of
volatile food and energy prices are removed.
However, should continued high energy prices
prompt core inflation to accelerate at a more
rapid rate in the coming months as businesses
may ultimately attempt to pass along cost
increases to consumers, the Federal Reserve may
be forced to remove monetary policy
accommodation at a more aggressive pace or risk
higher inflation premiums that would tend to
suppress economic growth.
Labor Market
After averaging
5.4% in the fourth quarter of 2004 and 5.3% in
the first quarter of 2005, the unemployment rate
continued to trend lower in the second and third
quarters to an average 5.1% and 5.0%,
respectively.
For the fourth quarter, the unemployment rate
remained at 5.0%. On a monthly basis,
unemployment was 5.2% in January, 5.4% in
February, 5.2% in March, 5.2% in April, 5.1% in
May, and 5.0% in June. For the third quarter,
unemployment was 5.0% in July, 4.9% in August,
and 5.1% in September. In the fourth quarter,
the unemployment rate was 4.9%, 5.0%, and 4.9%
in October, November, and December,
respectively.
Total nonfarm payroll employment increased by
124,000 in January, by 243,000 in February, and
by 110,000 in March, for a first quarter average
of 159,000 monthly job gains. As a result of
these gains, total nonfarm payroll employment
increased by 477,000 during the first quarter
after adding over 600,000 jobs in the fourth
quarter. For the second quarter, total nonfarm
payroll employment increased by roughly 542,000
for an average of 181,000 per month. In June,
total nonfarm payroll employment increased by
146,000 to 133.5 million following increases in
April and May of 292,000 and 104,000,
respectively. Total nonfarm payroll employment
increased by 277,000 in July, 211,000 in August,
and decreased by 35,000 in September (which
reflect the impact of Hurricane Katrina). In
the third quarter, total nonfarm payroll
employment increased by 453,000 or an average of
151,000 per month. For the fourth quarter,
total nonfarm payroll employment increased by
25,000 in October, 305,000 in November, and
108,000 in December. Total nonfarm paryroll
employment increased by 438,000 for the quarter
or an average of 146,000 per month.
Payroll gains in the quarter included
increases in professional & business services
and hospitality. Professional & business
service employment’s increased roughly 123,000
in the fourth quarter. The hospitality industry
added 69,000 jobs in the fourth quarter.
Manufacturing employment, which for the third
quarter lost nearly 37,000 jobs as compared to
the second quarter average employment, added
approximately 39,000 in the fourth quarter.
Average manufacturing employment in the fourth
quarter was 14,268,000 as compared to 14,258,000
in the third quarter.
According to the Conference Board’s
Consumer Confidence Survey, consumers’ optimism
regarding employment increased during the fourth
quarter following mixed sentiments during the
third quarter. Consumers expecting more jobs to
become available in the next six months
decreased in October to 12.3% from 14% in
September, increased to 14.1% in November and
remained virtually unchanged at 14.3% in
December. Those expecting fewer jobs to become
available fell to 24% in October from 24.8% in
September and declined again in November and
December to 18.1% and 18.0%, respectively.
Further increases in economic activity, even at
a much slower rate, should provide a foundation
for continued increases in payroll employment
for the coming quarters in 2006. However,
should continued high energy prices and rising
interest rates negatively impact consumer
sentiment, consumers’ optimism regarding
employment may deteriorate into the first half
of 2006, particularly if businesses adjust
payrolls to compensate for slower demand.
Equity Markets
After ending
2004 at roughly 10,850, the Dow Jones Industrial
Average (DJIA) fell roughly 3% in the first
quarter.
The S&P 500 declined by 2.6% in the first
quarter with the NASDAQ composite experiencing
the largest loss during the first quarter,
falling roughly 8%. For the second quarter, the
DJIA declined roughly 1.6% (through June 29th)
to 10,375. The NASDAQ and the S&P 500, however,
both posted gains of 3.2% and 1.6%,
respectively, ending the second quarter at
roughly 2,069 and 1,200. For the third quarter,
the DJIA increased by only 1% to end the quarter
at 10,473 (as of September 28th).
The S&P 500 and the NASDAQ increased by 1.4%
and 2.2% in the third quarter to 1,217 and
2,115, respectively.
For the fourth quarter, the DJIA
advanced 2.3% to end the year at 10,717.5. For
the full year, however, the DJIA lost 1.3%. The
S&P 500 increased 2.6% during the fourth quarter
to end the year at 1,248.3 for a gain of 2.9%
for 2005. The NASDAQ composite experienced the
largest fourth quarter gain of 4.3% to end the
year at 2,205.3, 1.3% higher on the year.
The mixed performance may have been a result of
continued caution on the part of investors due
to rising oil prices and the impact upon
economic activity, uncertainty regarding
geopolitical events, rising interest rates,
increased inflation expectations prompting a
flight to quality in government bonds, and the
potential for higher returns in the real estate
markets.
Concerns over corporate
earnings may have been one factor weighing upon
the equity markets. Wall Street analysts had
anticipated that the fourth quarter would ensure
that 2005 marked the longest sustained
acceleration in corporate profits since World
War II, with total profits of the S&P 500 index
anticipated to increase 14% on a year-over-year
basis as compared to a 16% increase in the third
quarter over 2004. In addition, analysts
expected profits to g |
