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State of the
Economy
2nd Quarter
2006
Introduction
Economic activity finally began to
exhibit additional signs of significant slowing
in the second quarter after mixed signals from
various economic data indicators and strong
economic growth during the first quarter. Real
gross domestic product (GDP)
increased at an annual rate of 2.5% in the
second quarter following an increase of 5.6% at
an annual rate during the first quarter of
2006. These figures compare to an increase of
1.8% in the fourth quarter of 2005 and an
increase of 3.2% for the full year 2005 on a
revised basis. The slowdown in real GDP comes
at a time of continued high energy prices and
further tensions stemming from geopolitical
risks. These factors likely weighed on
consumers who reigned in spending during the
second quarter. In addition, economic activity
was restrained due to decreases in federal
spending and real residential fixed investment
as well as significant slowdowns in real
nonresidential fixed investment and exports of
goods and services.
Higher energy prices, which likely
had an adverse impact upon consumer sentiment
and which contributed to increased inflationary
pressures, continue to be a trend that may
contribute to further economic softening in the
coming quarters. To be sure, the economy in the
remainder of 2006 is likely to exhibit signs of
slowing, with growth advancing at a rate below
the long-term sustainable rate of growth for the
economy.
Gross Domestic Product
Advance
estimates[1]
released by the Bureau of Economic Analysis
(BEA) indicate that real GDP increased at an
annual rate of 2.5% during the second quarter
following a revised increase of 5.6% in the
first quarter. This increase in GDP is lower
than the 3.3% increase in real
GDP
in the second quarter of 2005[2].
Economic growth during the quarter was below the
consensus forecast of 3.4% (unchanged from 3.4 %
anticipated when surveyed during the first
quarter) annual growth in real GDP anticipated
by fifty-three forecasters surveyed by the
Federal Reserve Bank of Philadelphia[3].
The consensus forecast is for a 3.1% increase
in real GDP in the third quarter and an increase
of 3.4% for the full year. Real
GDP increased at an annual rate of 3.2%
in 2005 as compared to an increase of 3.9% in
2004 and 2.5% in 2003.
Real personal consumption
expenditures, which accounts for about
two-thirds of economic activity, weakened in the
second quarter of 2006, increasing by 2.5% as
compared to a 4.8% increase in the first quarter
and a 0.8% increase in the fourth quarter. This
advance in real personal consumption
expenditures in the first quarter is the slowest
pace of increase since the first quarter of 2005
during which real personal consumption
expenditure increased by 2.7%. Following an
increase of 19.8% in the first quarter,
purchases of durable goods decreased by 0.5% in
the second quarter. This decrease in purchases
of durable goods was due to a roughly 1%
decrease in expenditure on motor vehicles and
parts as compared to a 5% increase in the first
quarter. This decrease in purchases of motor
vehicles may be attributed to weakened consumer
sentiment and restrained spending in light of
generally tepid economic conditions. This
slowdown in purchases of motor vehicles comes
despite reintroduction of sales incentives by
automobile manufacturers. Purchases of
furniture and household equipment decreased by
roughly 0.1% in the second quarter as compared
to a 4.2% increase in the previous quarter.
Data from the Federal Reserve Beige
Books released in the second quarter indicated
that several of the Federal Reserve Districts
noted that retail sales had been disappointing
overall during the observation period. Sales
were characterized as weak amongst the big box
retailers, restrained by continued elevated
gasoline prices. The trend towards more fuel
efficient vehicles in light of the elevated
energy prices and preference for foreign brands
over domestic automobiles continued during the
second quarter.
Personal consumption expenditures on
nondurable goods increased by 1.7% during second
quarter as compared to 5.9% during the first
quarter and 5.0% during the fourth quarter.
After showing signs of strength during the first
quarter, retail sales weakened during the second
quarter, increasing at a modest pace over the
prior year. Some retailers characterized the
growth in sales as disappointing or below
expectations, according to the Beige Book
reports. The strength in retail sales during
the first quarter may have been a result of the
redemption of holiday gift cards. The weakness
in retail sales during the second quarter may
have been the result of continued high energy
prices and gasoline prices that served to
squeeze household finances and restrain
spending.
Real nonresidential fixed investment
increased at a 2.7% rate in the second quarter
as compared to a 13.7% rate in the first quarter
and a 4.5% increase in the fourth quarter.
Equipment and software investment activity,
which increased by 5% in the fourth quarter and
by 15.6% in the first quarter, decreased by 1.0%
in the second quarter.
Following increases of $43.5 billion
in the fourth quarter and $41.2 billion in the
first quarter, private businesses increased
inventories by $52.6 billion in the second
quarter. The second quarter real change in
inventories added 0.4% to the change in real
GDP as compared to subtracting 0.03% from the
first quarter change in real GDP. This increase
in inventories may tend to suggest that
businesses continued to increase inventory
stocks that had been drawn down during the
fourth quarter holiday season and during the
first quarter. Businesses may also have
increased inventory levels in anticipation of
increased demand in coming quarters. With the
slowing in consumer spending that began to
emanate during the second quarter, businesses
may begin to cut back production and reduce
inventory build-ups in order to allow inventory
levels to come in line with reduced demand
expectations.
Real residential fixed investment
which increased by 2.8% in the fourth quarter of
2005, decreased in the first and second quarters
of 2006 by 0.3% and 6.3%, respectively. This
lower growth rate is likely indicative of a
continued slowing in real estate activity,
consistent with the deflating of the real estate
bubble that existed. This decrease in real
residential fixed investment is likely the
result of continued removal of accommodative
monetary policy by the Federal Reserve and a
subsequent increase in mortgage rates along with
more cautious lending by financial institutions
for real estate transactions and adverse
pressures on consumer finances due to continued
high energy prices.
Data on new residential construction
from the U.S. Census Bureau and U.S. Department
of Housing and Urban Development indicated that
activity continued to weaken in the second
quarter. Privately-owned housing units
authorized by building permits ended the fourth
quarter at 2,075,000. For the first quarter,
new privately-owned housing units authorized by
building permits advanced in January to
2,195,000 before falling to 2,147,000 in
February and 2,085,000 in March. For the second
quarter, new privately-owned housing units
authorized by building permits continued to
decline, falling to 1,973,000 in April,
1,946,000 in May, and 1,862,000 in June. As a
result, new privately-owned housing units
authorized decreased on a year-over-year basis
by 8.5% in April, 7.8% in May, and 14.9% in
June.
Privately-owned housing starts, which
ended the fourth quarter at 1,989,000 (below the
2,160,000 level at the end of the third
quarter), increased in January to 2,265,000 then
declined in February and March to 2,132,000 and
1,972,000, respectively. In the second quarter,
privately-owned housing starts decreased in
April to 1,832,000, rebounded to 1,953,000 in
May, then declined again in June to 1,850,000.
On a year-over-year basis, housing starts
declined in April by 11.9%, 4% in May, and by
11% in June.
Sales of new
and existing homes, which had decelerated during
the first quarter, continued to slow during the
second quarter of 2006. Data from the National
Association of Realtors (NAR)
[4]
indicates that, after ending December at
6,750,000 units on a seasonally adjusted
annualized basis (down from 7,200,000 in
September), existing home sales continued to
decline in January, falling to 6,570,000.
Existing home sales rose to 6,900,000 in
February and 6,900,000 in March. On a
year-over-year basis, sales of existing homes
decreased 1% in March and by 8.9% in June. The
inventory of existing homes on the market
continued to increase during the second quarter
to 3,730,000 as compared to 3,194,000 in March.
As a result, the backlog of existing homes
increased further from 5.1 months in December to
5.5 months in March to 6.8 months in June. New
home sales also declined in the first quarter of
2006, falling in January to 1,197,000, in
February to 1,038,000, and increasing sharply in
March to 1,121,000. On a year-over-year basis,
however, new home sales in March declined
roughly 7%. For the second quarter, new home
sales remained steady at 1,121,000 in April,
1,130,000 in May, and 1,120,000 in June.
Through the end of the first half of the year,
new home sales were roughly 14% lower on a
year-over-year basis. The inventory of new
homes also continued to increase to 6.5 months
supply in June as compared to a 5.5 months
supply in March. This is a sharp increase from
the prior year’s level of 4.3 months.
The national
median sales price of all existing homes fell
from $222,000 in December to $218,000 in March,
lower than the high of $229,000 first set in
June 2005. For the full year 2005, the median
price was $219,600. The median price of new
homes was $224,000 in March, a decline of 2% in
the last year. By June, the national median
sales price of existing homes had trended
upwards to roughly $230,000, an increase of 0.9%
on a year-over-year basis[5].
Ben Bernanke, Chairman of
the Federal Reserve, suggested that the real
estate markets were likely experiencing a period
of cooling activity, stating in testimony to the
Committee on Financial Services, U.S. House of
Representatives, on
February 15, 2006 upon delivering the
Semiannual Monetary Policy Report to the
Congress[6]:
…Some cooling of the housing market is to be
expected and would not be inconsistent with
continued solid growth of overall economic
activity. However, given the substantial gains
in house prices and the high levels of home
construction activity over the past several
years, prices and construction could decelerate
more rapidly than currently seems likely.
Slower growth in home equity, in turn, might
lead households to boost their saving and trim
their spending relative to current income by
more than is now anticipated…
…However, as I have already noted, some signs of
slowing in the housing market have appeared in
recent months: Home sales have softened, the
inventory of unsold homes has risen, and
indicators of homebuilder and homebuyer
sentiment have turned down. Anecdotal
information suggests that homes typically are on
the market somewhat longer than they were a year
or so ago, and the frequency of contract offers
above asking prices reportedly has diminished.
Financial market conditions seem to be
consistent with some moderation in housing
activity…Thus, at this point, a leveling out or
a modest softening of housing activity seems
more likely than a sharp contraction, although
significant uncertainty attends the outlook for
home prices and construction.
Chairman Bernanke reiterated this
position of cooling activity in the real estate
markets in testimony to the Committee on
Banking, Housing, and Urban Affairs, U.S.
Senate, on
July 19, 2006
upon delivering the Semiannual Monetary
Policy Report to the Congress[7]:
Outlays for residential construction, which have
been at very high levels in recent years, rose
further in the first quarter. More recently,
however, the market for residential real estate
has been cooling, as can be seen in the slowing
of new and existing home sales and housing
starts. Some of the recent softening in housing
starts may have resulted from the unusually
favorable weather during the first quarter of
the year, which pulled forward construction
activity, but the slowing of the housing market
appears to be more broad-based than can be
explained by that factor alone. Home prices,
which have climbed at double digit rates in
recent years, still appear to be rising for the
nation as a whole, though significantly less
rapidly than before. These developments in the
housing market are not particularly surprising,
as the sustained run-up in housing prices,
together with some increase in mortgage rates,
has reduced affordability and thus the demand
for new homes.
The Beige Books released on
January 18, 2006,
March 15, 2006
and
April 26, 2006
indicated moderation in residential real estate
activity in most of the twelve Districts during
the first quarter, following some cooling of
activity 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. However, residential
construction was mixed throughout with country,
with continued strong activity in the West and
South. Kansas City, Minneapolis, St. Louis, and
Chicago all noted slower residential
construction activity. Condominium projects
throughout the South were put on hold during the
first quarter as demand for condos remained
soft.
The Beige Books released on
June 14, 2006
and
July 26, 2006
confirm earlier reports of a slowing in real
estate activity. Most of the Districts reported
slower homebuilding and sales of existing
homes. Only Dallas and Richmond indicated that
activity remained strong during the first half
of the second quarter. Condominium sales showed
weakness in many Districts, with projects in the
Atlanta District being cancelled due to lack of
interest. By the end of the second quarter,
only
St. Louis
and Dallas indicated resilience in the real
estate markets. Overall, the data included in
the Beige Books from the second quarter continue
to confirm signs of weakening real estate
markets, a trend that originally began to
manifest in the third quarter of 2005.
Thirty-year
conventional mortgage rates, according to
Freddie Mac[8],
rose slightly during the first quarter from
6.27% at the end of 2005 to a high of roughly
6.37% in early March before ending the quarter
at 6.35%. By mid-April, thirty-year rates had
increased further to 6.49%. Thirty-year rates
continued to climb during the second quarter,
reaching a high of 6.78% on
June 29, 2006.
After ending the fourth quarter at approximately
5.82%, fifteen-year mortgage rates increased to
6.00% by early March. After ending the first
quarter at 6.00%, fifteen-year rates increased
further to 6.14% by mid-April. By the end of
the second quarter, fifteen-year rates had risen
to 6.43%.
The rise in
mortgage rates coincides with U.S. Treasury
yields on the 10-year note, which increased from
4.39% at the end of December 2005 to 4.53% by
the end of January. By the end of the first
quarter, the yield on the 10-year note had
increased to 4.86%. The yield continued to
increase through mid-April to roughly 5%. The
yield reached a high of 5.19% in mid-May before
falling to 4.97% in early June. By the end of
the second quarter, the yield on the 10-year
note had increased again to 5.15%. By the end
of the fourth quarter, the yield curve had
inverted with the two-year yield rising just
slightly above the yield on the ten-year note[9].
Though this inversion was reversed in early
January, the yield curve inverted once again by
the middle of the month before reversing by the
end of January. The yield curve remained
virtually flat during the remainder of the first
quarter. During the second quarter, the yield
curve inverted again in early June and remained
inverted or flat for the duration of the second
quarter.
The Federal Reserve’s removal of
accommodative monetary policy in the second
quarter may also contribute to further slowing
of real estate activity in the coming quarters.
The adverse impact rising mortgage rates may
have upon speculators in the real estate markets
and investors who have committed to degrees of
leverage which they may not be able to service
could have the effect of continuing to remove
some of the “froth” in certain local real estate
markets throughout the
U.S. However, this may create certain increased
risks for investors and holders of debt secured
by real estate which could translate into
heightened dangers for the economy as a whole
should investors in real estate be squeezed out
of the market and be forced to sell properties
at reduced prices.
Following a revised increase of 5.1%
in the fourth quarter and 14% in the first
quarter, real exports of goods and services for
the second quarter increased at a more modest
rate of 3.3%. Imports, a subtraction from
GDP, increased 0.2% in the second quarter as
compared to an increased of 9.1% in the first
quarter and a 12.1% increase in the fourth
quarter of 2005.
The
dollar/sterling ($/£) exchange rate ended 2005
at $1.75, stronger than at the beginning of 2005
when the exchange rate was roughly $1.92.
During the first quarter, the dollar weakened to
$1.79 against the pound sterling by the end of
January before gaining to end the quarter at
$1.72. During the second quarter, the dollar
weakened further to $1.89 by the end of May
before gaining slightly to end the quarter at
$1.82. The dollar/euro ($/ˆ) exchange rate was
$1.35 at the end of the fourth quarter of 2004
and $1.20 at the end of the fourth quarter of
2005. During the first quarter of 2006, the
dollar weakened to $1.22 against the euro by the
end of January. By the end of the quarter, the
dollar had strengthened to $1.20. The dollar
weakened against the euro during the second
quarter to $1.28 by the end of May before rising
to $1.25 by the end of the June. At the end of
2005, the yen/dollar (¥/$) exchange rate stood
at ¥116. During the first quarter of 2006, the
dollar continued to gain strength against the
yen. By early February, the dollar had
strengthened to ¥119[10]
before retrenching slightly to ¥118 by the end
of the quarter. During the second quarter, the
dollar weakened to ¥111 around the end of May
before rising slightly to ¥116 by the end of
June.
The initial weakening of the dollar
during January may have been the result of weak
economic data for the fourth quarter. As growth
expectations were revised upwards and
expectations for a rebound in economic activity
began to manifest mid-quarter, investors may
have had renewed confidence in prospects for
economic growth in the
U.S. This may have prompted the strengthening
of the dollar late in the first quarter.
However, this strength of the dollar was
short-lived, particularly in light of weaker
economic activity during the second quarter and
lower growth expectations and higher inflation
expectations going forward.
However, the
U.S. current account
deficit remains a significant threat to the
strength of the dollar. For the first quarter
of 2006, the current account deficit decreased
to $208.7 billion from $223.1 billion in the
fourth quarter of 2005. The current account
deficit was $185.4 billion in the third quarter
of 2005 and $805 billion for the full year[11].
To be sure, continued rapid rises in the current
account deficit are unsustainable in the
long-term. In order to reduce the current
account deficit,
U.S.
exports would have to increase by upwards of 70%
or the dollar would have to depreciate
significantly accompanied by a sharp reduction
in domestic demand. With foreigners acquiring
U.S. assets in order to satisfy the
U.S.
consumption of imported goods, there is a great
risk to economic growth stemming from reliance
upon foreigners’ continued willingness to fund
the current account. Should the proclivity of
foreign investors towards dollar denominated
assets fall, the dollar would likely weaken
significantly and interest rates would be forced
to rise significantly in order to attract
investment in U.S. financial assets.
After increasing by 8.8% in the first
quarter, real federal government consumption
expenditures decreased by 3.4% during the second
quarter. This compared to a decrease of 2.6% in
the fourth quarter of 2005. National defense
spending, which increased by 8.9% in the first
quarter as compared to a decrease of 8.9% in the
fourth quarter, decreased 1.0% in the second
quarter. Nondefense spending decreased 7.8%
after an increase of 8.5% in the first
quarter.
The Federal Reserve
The Federal
Reserve’s gradual removal of monetary policy
accommodation continued during the second
quarter of 2006, with the Federal Open Market
Committee (FOMC) increasing the federal funds
rate to 5 ¼%[12].
At its meeting on
January 31, 2006, the
final meeting chaired by Alan Greenspan, the
FOMC agreed its fourteenth twenty-five basis
point increase in the target for the federal
funds rate to 4 ½%[13].
The FOMC stated that it believed economic
activity remained solid, with core inflation
remaining relatively low and long-term inflation
expectations contained. The Committee also
judged that resource utilization increases and
continued high energy prices could add to
inflationary pressures. The Committee further
concluded that further policy firming could be
necessary.
At its meeting on
March 28, 2006, the first
chaired by Ben Bernanke, the FOMC agreed another
twenty-five basis point increase in the target
for the federal funds rate to 4 ¾%[14].
The Committee indicated the following:
The slowing of the growth of real GDP in the fourth quarter of 2005 seems largely to
have reflected temporary or special factors.
Economic growth has rebounded strongly in the
current quarter but appears likely to moderate
to a more sustainable pace. As yet, the run-up
in the prices of energy and other commodities
appears to have had only a modest effect on core
inflation, ongoing productivity gains have
helped to hold the growth of unit labor costs in
check, and inflation expectations remain
contained. Still, possible increases in resource
utilization, in combination with the elevated
prices of energy and other commodities, have the
potential to add to inflation pressures.
The Committee judges that some further policy
firming may be needed to keep the risks to the
attainment of both sustainable economic growth
and price stability roughly in balance. In any
event, the Committee will respond to changes in
economic prospects as needed to foster these
objectives.
…Still, possible increases in resource
utilization, in combination with the elevated
prices of energy and other commodities, have the
potential to add to inflation pressures.
At the May 10,
2006 meeting, the FOMC increased the federal
funds rate by twenty-five basis points to 5%[15]
and indicated the following:
Economic growth has been quite strong so far
this year. The Committee sees growth as likely
to moderate to a more sustainable pace, partly
reflecting a gradual cooling of the housing
market and the lagged effects of increases in
interest rates and energy prices.
At its
June 29, 2006 meeting the
FOMC agreed another increase in the federal
funds rate to 5 ¼%[16],
the Committee’s seventeenth consecutive
increase. The Committee reiterated that the
cooling housing market and effects of interest
rate increases and higher energy prices had
contributed to the gradual cooling in economic
activity. With respect to inflation, the
Committee indicated the following:
Readings on core inflation have been elevated in recent
months. Ongoing productivity gains have held
down the rise in unit labor costs, and inflation
expectations remain contained. However, the
high levels of resource utilization and of the
prices of energy and other commodities have the
potential to sustain inflation pressures.
Although the moderation in the growth of
aggregate demand should help to limit inflation
pressures over time, the Committee judges that
some inflation risks remain. The extent and
timing of any additional firming that may be
needed to address these risks will depend on the
evolution of the outlook for both inflation and
economic growth, as implied by incoming
information. In any event, the Committee will
respond to changes in economic prospects as
needed to support attainment of its objectives.
In the Monetary Policy Report to
the Congress, released
July 19, 2006, the Federal Reserve policymakers
indicated that the economy was transitioning
from a period of growth that is above the
long-run sustainable rate to a more moderate and
sustainable rate. The Federal Reserve Board of
Governors and Federal Reserve Bank Presidents
project that real
GDP will increase by 3 ¼%-3 ½% (central
tendency) in 2006 as compared to real
GDP
growth of 3.5% in 2005[17].
Real GDP is expected to increase by 3%-3 ¼% in
2007. The personal consumption expenditures
chain-type price index (the Federal Reserve’s
preferred measure of inflation) excluding food
and energy is expected between 2 ¼%-2 ½% in
2006, as compared to the 1.9% increase in 2005.
For 2007, the PCE index excluding food and
energy is expected to be 2%-2 ¼%. The civilian
unemployment rate is anticipated to range from 4
½%-5% in 2006, against 5% for 2005, and 4 ¼%-5
¼% in 2007.
In testimony accompanying delivery of
the Semiannual Monetary Policy Report to the
Congress before the Committee on Banking,
Housing, and Urban Affairs, U.S. Senate, on
July 19, 2006 Chairman Ben Bernanke indicated
the following:
The
U.S. economy appears to be in a period of transition.
For the past three years or so, economic growth
in the
United States has been robust. This growth has reflected both
the ongoing re-employment of underutilized
resources, as the economy recovered from the
weakness of earlier in the decade, and the
expansion of the economy's underlying productive
potential, as determined by such factors as
productivity trends and growth of the labor
force. Although the rates of resource
utilization that the economy can sustain cannot
be known with any precision, it is clear that,
after several years of above-trend growth, slack
in resource utilization has been substantially
reduced. As a consequence, a sustainable,
non-inflationary expansion is likely to involve
a modest reduction in the growth of economic
activity from the rapid pace of the past three
years to a pace more consistent with the rate of
increase in the nation's underlying productive
capacity. It bears emphasizing that, because
productivity growth seems likely to remain
strong, the productive capacity of our economy
should expand over the next few years at a rate
sufficient to support solid growth in real
output.
As I have noted, the anticipated moderation in
economic growth now seems to be under way,
although the recent erratic growth pattern
complicates this assessment. That moderation
appears most evident in the household sector. In
particular, consumer spending, which makes up
more than two-thirds of aggregate spending, grew
rapidly during the first quarter but decelerated
during the spring. One likely source of this
deceleration was higher energy prices, which
have adversely affected the purchasing power of
households and weighed on consumer attitudes.
The impact of higher energy prices is
likely to continue to be felt for quarters to
come. Inflation is likely to feel continued
upward pressures, 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 remain well oiled, they are unlikely to
continue running at a robust pace in the
short-term, particularly 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[18]
released on
May 10, 2006 and
June 14, 2006
confirmed the slowdown in economic activity
throughout the twelve Districts[19]
that characterized the second quarter. The
Beige Book conclusions included the following:
-
Consumer spending increased at a more modest
rate with noticeable signs of weakness.
High gasoline prices and rising interest
rates were cited as possible causes for the
softness in consumer spending. Retail
inventories were characterized as being at
desired levels throughout the country.
Automobile sales were characterized as weak
with vehicle inventories remaining above
desired levels.
-
Manufacturing activity expansion was strong
once again, though more Districts indicated
signs of some softening in activity.
Activity in production of goods for the
energy, semiconductor and aerospace
industries exhibited strength in many
Districts. Demand for building supplies was
weak in several Districts.
-
Residential real estate activity continued
to cool during the second quarter,
continuing a trend that was evident earlier
in the year. Most Districts noted slowing
home sales and homebuilding as well as a
deceleration in price appreciation.
Commercial real estate activity continued to
exhibit strength, following the trend that
originally began during the third quarter of
2005. Demand for office space continued to
edge up throughout many Districts, though
rising construction costs had prompted a
scaling back or redesign of anticipated
projects.
-
Gains in employment figures prompted a
slight tightening of labor markets
throughout the country. There were some
shortages of skilled workers noted in many
Districts. Wage pressures had intensified
in some Districts, particularly for skilled
positions, since the previous quarter.
Consumer Confidence
The Conference
Board’s Consumer Confidence Index[20]
ended 2005 at 103.8 and continued the
strengthening trend in the first quarter, rising
to 106.8 in January, 102.7 in February, and
107.5 in March. At the end of the first
quarter, the Consumer Confidence Index had risen
to the highest level in nearly four years. Lynn
Franco, Director of The Conference Board’s
Consumer
Research Center, indicated the following with
respect to the consumer confidence figures:
The improvement in consumers’ assessment of
present-day conditions is yet another sign that
the economy gained steam in early 2006.
Consumer expectations, while improved, remain
subdued and still suggest a cooling in activity
in the latter half of this year.
During the second quarter, the
Consumer Confidence Index rose slightly in April
to 109.8, declined significantly to 104.7 in
May, and improved modestly to 105.4 in June.
After reaching a four year high in April,
consumers’ concern regarding the short-term
outlook for the economy and labor markets
prompted the retrenchment in May. This is
likely a result of the incoming economic data
that dampened consumers’ spirits regarding the
strength of economic activity.
After ending 2005 at 92.6, the
Expectations Index declined to 92.1 in January
and 84.2 in February before rising to 90.3 in
March. The decline in the Expectations Index
during the first quarter may be attributed to
consumers’ anticipation of slowing economic
growth and less favorable jobs prospects. The
drop to 84.2 in February placed the Expectations
Index at its lowest level in three years, with
the exception of the two months following
Hurricane Katrina. During the second quarter,
the Expectations Index followed a pattern
similar to that of the Consumer Confidence
Index—rising slightly in April to 92.3, falling
to 85.1 in May and improving slightly to 87.5 in
June. The fall in the Expectations Index likely
suggests the potential for continued slowing of
economic activity in the second half of the
year.
Consumers’ outlook for the next six
months was less favorable during the first
quarter. In January, February, and March,
17.9%, 16.2%, and 17.8%, respectively, expected
business conditions to improve in the next six
months. Those expecting conditions to worsen
decreased in March to 9.8% from 10.9% in
February and 10.5% in January. In the second
quarter, consumers expecting conditions to
improve in the next six months stood at 17.3% in
April, 16.5% in May, and 16.8% in June. Those
expecting conditions to worsen in the second
quarter decreased in April to 9.3%, increased in
May to 12.9% and decreased in June to 11.8%.
Consumers’ assessment of current
business conditions was mixed during the first
quarter. With 24.4% of respondents
characterizing current conditions as “good” in
December 2005, this figure improved to 25.9% in
January, 26.4% in February, and 27.9% in March.
Those characterizing conditions as “bad” stood
at 14.9% in December 2005. In January,
February, and March, 15.9%, 15.4%, and 14.7%
characterized conditions as “bad,”
respectively. In April, May, and June, 29.7%,
28.5%, and 26.6% characterized conditions as
“good,” a slight drop from the end of the first
quarter. Those characterizing conditions as
“bad” stood at 15.1% in April, 15.2% in May, and
15% in June. These figures are higher than at
the end of the first quarter but slightly below
the levels gauged earlier in the year.
The improvement in the first quarter
may have been the result of momentum in consumer
confidence that paralleled momentum in economic
activity during the same period. The shift to a
more guarded assessment of economic activity
during the second quarter may have been the
result of incoming economic data that tended to
show weakening from previously robust levels.
The deterioration in optimism during the second
quarter may indicate that consumers are becoming
more cognizant of the actual long-term threats
to economic growth stemming from factors such
continued elevated energy prices, increased
interest rates, a slowing housing market, etc.
As the actual impact these factors have upon
economic activity continues to manifest in
coming months, consumer confidence may fall
further and prompt restrained spending, which
could additionally contribute to weakened
economic growth during the coming quarters.
The Business Sector
Industrial
production, as compiled by the Federal Reserve[21],
increased at a revised annual rate of 5.3%
during the fourth quarter of 2005 and by 5.1%
for the first quarter of 2006[22].
For the second quarter, industrial production
increased at an annual rate of 6.6%. For the
full year 2005, industrial production increased
3% over the 2004 level. On a year-over-year
basis, industrial production increased by 3.1%,
3.3%, and 3.6% in January, February, and March,
respectively, and by 4.7%, 4.3%, and 4.5% in
April, May, and June, respectively.
Manufacturing production, which
increased at an annual rate of 9.1% in the
fourth quarter and 5.3% in the first quarter,
advanced by an annual rate of 5.4% in the second
quarter of 2006. Once again, the continued
strength in manufacturing is confirmed by
anecdotal evidence contained in The Beige Book
releases from the Federal Reserve, which
indicated generally favorable manufacturing
gains throughout the twelve Districts.
Manufacturing production increased by 4.5%,
4.2%, and 4.8% on a year-over-year basis in
January, February, and March, respectively, and
by 5.5%, 4.9%, and 5.7% in April, May, and June,
respectively.
Durable goods production, which
increased by 2.8% in the fourth quarter but
declined at an annual rate of 1.8% in the first
quarter, advanced at an annual rate of 1.6% in
the second quarter. Nondurable goods
production, which increased by 1.4% in the
fourth quarter and decreased by 0.8% in the
first quarter of 2006, advanced at an annual
rate of 4.9% in the second quarter of 2006.
Defense and space equipment production continued
to experience strong gains, increasing by 6.8%
and 7.4% in the first and second quarters,
respectively, compared with an increase of 8.1%
in the fourth quarter of 2005. Following a
fourth quarter increase of 17.4%, construction
supplies advanced by a more modest 3.2% in the
first quarter (revised) and declined by 0.9% in
the second quarter. This retrenchment in
construction supplies is likely the result of
continued cooling in housing activity
nationwide.
On a quarterly basis, capacity
utilization increased to 82% in the second
quarter, following an increase in the first
quarter of 2006 to 81.1% as compared to 80.5%
for the fourth quarter. This level of 82% is
1% above the 1972 to 2005 average. 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 to 80.9% in the second quarter as
compared to 80.3% in the first quarter and 79.8%
in the fourth quarter. At this level, capacity
utilization is now above the 1972 to 2004
average of 79.8%. At these levels of resource
utilization, there is still considerable slack
in the productive capabilities of factories
throughout the
United States.
As such, capacity utilization rates should not
pose a significant threat to rising inflationary
pressures, even though the utilization rates are
slightly above the historical norms.
The Department
of Commerce’s[23]
advance monthly sales for retail trade and food
services showed solid gains in the first
quarter. In March, retail and food service
sales increased by approximately 0.6%[24]
from February to $361 billion. Total retail
sales increased by 0.7% in March from the
February level to $325.9 billion. During the
second quarter, retail trade and food services
sales were tepid, increasing to $363.6 billion
in April and to $364.1 billion in May before
falling to $363.8 billion in June. Total retail
sales followed a similar pattern in the second
quarter, increasing to $328.4 billion and $328.8
billion in April and May, respectively, then
falling slightly to $328.4 billion in June.
On a year-over-year basis, monthly
sales for retail trade and food service
increased 9.4% in January, 7.5% in February, and
7.9% in March. In April, May, and June, monthly
sales for retail trade and food services
increased 6.9%, 7.6%, and 5.9%, respectively, on
a year-over-year basis. For the second quarter,
advance monthly retail and food service sales
increased 0.9% from the first quarter. This
compares to an increase of 3.2% in the first
quarter from the fourth quarter of 2005. On a
year-over-year basis, advance monthly sales for
retail trade and food services increased 8.3% in
the first quarter. In the second quarter,
monthly sales for retail trade and food services
increased 6.8% on a year-over-year basis. For
the first quarter, retail sales increased by
3.2% from the fourth quarter and by 8.2% on a
year-over-year basis. For the second quarter,
retail sales increased by 1% from the first
quarter and by 6.7% as compared to the same
period a year ago. Total sales excluding motor
vehicles and parts increased by 1.6% in the
second quarter over the first and by 8.9% on a
year-over-year basis. This compares to an
increase of 2.7% in the first quarter from the
fourth quarter and by 9.7% on a year-over-year
basis. Sales of motor vehicles and parts, which
declined by 3.8% in the fourth quarter as
compared to the third quarter and by 1.8% from
the fourth quarter of the prior year, increased
in the first quarter by 5.2% and by 3.3% on a
year-over-year basis. Sales of motor vehicles
and parts declined 1.7% in the second quarter as
compared to the first quarter and by 0.5% on a
year-over-year basis.
The Chief
Executives’ Confidence Measure, compiled by the
Conference Board in the quarterly CEO
Confidence Survey, indicated that CEOs’
confidence improved slightly in the first
quarter with the index increasing to 57 from 56
in the fourth quarter[25].
However, the index declined to 50 for the second
quarter of 2006. In the first quarter, roughly
49% of CEO’s indicated that current economic
conditions were better. In the second quarter,
only 27% claimed current economic conditions are
better. Only 21% of the CEO’s surveyed expect
better conditions in the coming months, a
decline from 41% in the fourth quarter and 35%
in the first quarter.
Lynn Franco, Director of The
Conference Board Consumer Research Center,
stated the following with respect to the survey:
CEO’s confidence has waned in the second quarter
and expectations signal slower economic growth
in the coming months. However, the majority of
CEO’s do not foresee slower growth having an
adverse impact on corporate profits.
With energy prices expected to remain
elevated and interest rates continuing to rise,
consumer confidence and confidence amongst
business leaders may be further dampened and
prompt a retrenchment in consumption
expenditures and production. In addition,
continued deterioration in the real estate
markets may further weaken consumer confidence
and lessen personal consumption expenditures as
equity extraction from homes wanes. Overall,
these factors tend to suggest that the strength
of economic activity in the first quarter was
likely a temporary aberration and that the
slowdown in economic activity that began during
the fourth quarter of 2005 may continue with
weaker economic conditions in the second half of
2006.
Inflation
Following a 3.4% increase in the
consumer price index (CPI)
[26] for
the full year 2005 at a seasonally adjusted
annual rate, the CPI increased by a compound
annual rate of 4.3% in the first quarter of 2006
and by 5.1% for the second quarter. The CPI
increased 0.7% in January, 0.1% in February, and
0.4% in March on a seasonally adjusted basis.
In April, May, and June, the CPI increased 0.6%,
0.4%, and 0.2%, respectively. For the twelve
months ending in March, the
CPI
increased at an annual rate of 3.4%. For the
twelve months ending in June, the
CPI
increased at an annual rate of 4.3%.
For 2005, the energy index increased
by 17.1% on a seasonally adjusted annual basis.
For the first quarter of 2006, the energy index
increased by 21.8%, as a result of continued
elevated energy prices. For the second quarter,
the energy index increased 23.8%. For the
twelve months ending in March and June, the
energy index advanced by 17.3% and 23.3%,
respectively. Food prices during 2005 increased
at an annual rate of 2.3%. For the first and
second quarters of 2006, the food index advanced
at an annual rate of 2.5% and 1.7%. For the
twelve months ending in March and June, the food
index increased by 2.6% and 2.2%.
Removing the effects of food and
energy, the core
CPI increased by a seasonally adjusted annual
rate of 2.8% in the first quarter and by 3.6% in
the second quarter, perhaps indicating a pass
through of higher costs by businesses to
consumers. The core CPI advanced at a rate of
2.2% for both 2004 and 2005. For the twelve
months ending in June, the core CPI advanced at
a rate of 2.6% as compared to a rate of 2.1% for
the twelve months ending in March.
In addition to the
CPI, the price index for
personal consumption expenditures (PCE) from the
BEA[27]
rose by 4.1% in the second quarter as compared
to an increase of 2.0% in the first quarter, a
2.9% increase in the fourth quarter, and a 2.9%
increase for the full year 2005. On a
year-over-year basis, the PCE rose by 3.0% in
the first quarter and by 3.3% in the second
quarter. The PCE excluding food and energy
prices increased 2% and 2.3% on a year-over-year
basis in the first and second quarters of 2006.
With respect to inflation, Chairman
Ben Bernanke indicated the following in his
Congressional testimony from
July 19, 2006:
…The recent rise in inflation is of concern to
the FOMC. The achievement of price stability is
one of the objectives that make up the Congress’
mandate to the Federal Reserve. Moreover, in
the long run, price stability is critical to
achieving maximum employment and moderate
long-term interest rates, the other part of the
congressional mandate...
Although our baseline forecast is for moderating
inflation, the Committee judges that some
inflation risks remain. In particular, the high
prices of energy and other commodities, in
conjunction with high levels of resource
utilization that may increase the pricing power
of suppliers of goods and services, have the
potential to sustain inflation pressures. More
generally, if the pattern of elevated readings
on inflation is more protracted or more intense
than is currently expected, this higher level of
inflation could become embedded in the public’s
inflation expectations and in price-setting
behavior. Persistently higher inflation would
erode the performance of the real economy and
would be costly to reverse…
It appears that the increase in core
inflation accelerated in the second quarter,
prompted perhaps by a willingness of businesses
to begin passing increased costs onto the
consumers. Continued high energy prices may
ultimately prompt further upward inflationary
pressures at a more rapid rate in the coming
months. The core inflationary pressures could
be further pronounced should businesses be
successful in continuing to pass along cost
increases to consumers. An unexpected increase
in core inflation may force the Federal Reserve
to continue tightening monetary policy beyond
levels currently anticipated by the markets or
risk higher inflation premiums that would tend
to suppress economic growth and that would, as
Chairman Bernanke stated, be costly to reverse.
Labor Market
After averaging
5.0% in the fourth quarter of 2005, the
unemployment rate fell to 4.7% in the first
quarter and held steady at that rate for the
second quarter[28].
On a monthly basis, unemployment was 4.7% in
January, 4.8% in February, 4.7% in March, 4.7%
in April, and 4.6% in both May and June.
Total nonfarm payroll employment
increased by 154,000 in January, by 225,000 in
February, and by 211,000 in March, for a first
quarter average of 197,000 monthly job gains.
As a result of these gains, total nonfarm
payroll employment increased by 590,000 during
the first quarter of 2006 as compared to an
increase of 477,000 during the first quarter of
2005. In March, total nonfarm payroll
employment stood at 134.996 million.
In the second quarter, total nonfarm
payroll employment increased by 325,000 or a
monthly average of 108,000 job gains. For the
twelve months ending in March, average monthly
job gains stood at 169,000. Total nonfarm
payroll employment increased by 112,000 in
April, 92,000 in May, and 121,000 in June. By
the end of the quarter, total nonfarm payroll
employment stood at 135.230 million.
Payroll gains in the quarter included
increases in professional & business services,
government, and education & health services.
Professional & business service employment
increased roughly 82,000 in the second quarter
as compared to adding 93,000 jobs in the first
quarter and 123,000 in the fourth quarter.
Government employment increased by 68,000 in the
second quarter with education & health services
increasing by 86,000. Manufacturing employment
gained 26,000 jobs after losing roughly 10,000
during the first quarter.
According to the Conference Board’s
Consumer Confidence Survey, consumers’ optimism
regarding employment was mixed during the first
quarter. Consumers expecting more jobs to
become available in the next six months
decreased in January to 13.6% from 14.3% in
December. In February and March, 13.4% and
13.9% expected more jobs to become available,
respectively. For the second quarter, 15.4% in
April expected more jobs to become available in
the coming months, 14.8% in May, and 15.6% in
June. Those expecting fewer jobs to become
available ended 2005 at 17.7%. In January,
February, and March, 15.2%, 19.9%, and 16.6%
expected fewer jobs to become available in the
next six months, respectively. In April, May,
and June, 16.3%, 18.0% and 17.0% expected fewer
jobs to become available in the next six
months.
The slowdown in economic activity
that has slowly manifested during the second
quarter is likely to result in lower payroll
employment gains in the coming months. In
addition, continued elevated energy prices and
rising interest rates may negatively impact
consumer sentiment, leading consumers’ optimism
regarding employment to deteriorate. This may
be more pronounced should businesses and
manufacturers adjust payrolls to compensate for
waning demand. Given a slowing in economic
activity, further drops in the unemployment rate
are not likely. Should the unemployment rate
increase due to waning demand for goods and
services, the shortages of skilled workers that
have been noted throughout the nation may ease.
As a result, the inflationary pressures that
have attended the shortage of skilled workers
are likely to ease.
Equity Markets
The Dow Jones
Industrial Average (DJIA) ended 2005 at roughly
10,718[29].
The S&P 500 and the NASDAQ composite ended 2005
at 1,248 and 2,205, respectively. During the
first quarter, the DJIA gained roughly 4.7%
(through March 29th) to 11,216. The
NASDAQ and the S&P 500 gained 6.0% and 4.4%,
respectively, ending the quarter at roughly
2,338 and 1,303. During the first quarter, the
S&P 500 crossed the 1,300 level for the first
time since May 2001. The second quarter’s weak
economic activity accompanied at downturn in the
markets with the DJIA falling roughly 2% to end
the quarter at roughly 11,000. The NASDAQ
composite and the S&P 500 also fell during the
quarter by 9.7% and 4.4%, respectively, to
roughly 2,100 and 1,250.
The poor performance of the equity
markets during the second quarter may have been
a result of investor pessimism regarding
prospective economic activity and corporate
earnings in the second half of the year along
with factors related to the typically slow
summer season. Though the diminishing
opportunity for superior returns in the real
estate market may have prompted investors to
return to the equity markets earlier in the
year, it appears that investors turned to other,
less risky asset classes. Elevated oil prices
and the potential for adverse impacts upon
economic activity, uncertainty regarding
geopolitical events, tightening of monetary
policy by the Federal Reserve, and increased
inflation expectations may have also dampened
investors’ confidence in the equity markets.
Sustained high energy prices in the
coming months could have more far-reaching
adverse impacts upon corporate profits, economic
activity, and the equity markets. Inflationary
pressures stemming from higher energy prices
feeding into the core inflation figures could
also have an adverse impact upon investor
confidence. As a result of the aforementioned
risk factors, the ability of the equity markets
to post significant gains over the coming
quarters may yet be tenuous, particularly as a
number of factors may contribute to further
economic softness and rising inflationary
pressures in the coming quarters.
Oil Prices
West Texas Intermediate (WTI) oil
prices, which fluctuated in a band from $56 to
$64 per barrel during the fourth quarter and
from $60 to $66 per barrel during the first
quarter, remained at elevated levels during the
second quarter of 2006 ranging from $66 to $75
per barrel. Oil prices rose throughout January,
reaching nearly $70 per barrel by late in the
month on concerns of shortages of refining
capacity and the potential supply shortfalls for
the anticipated increase in demand during the
second quarter.
At the
January 31, 2006 meeting in
Vienna,
Austria[30],
OPEC ministers maintained its current production
level of 28.0 million barrels per day and noted
the following with respect to energy markets:
The Conference also noted that, although the
market is well supplied with crude oil, and
commercial oil stock levels in the OECD remain
healthy, prices have continued to rise. This,
however, is primarily a result of refining
bottlenecks and other non-fundamental factors…
…Early indications suggest that the world
economy will perform well in the first half of
2006; indeed, the forecast for world
GDP
growth for the whole of this year has already
been increased slightly, reflecting improved
expectations for Europe, Japan, and China,
though risks remain visible on global financial
imbalances, and higher interest rates,
particularly in the US. With substantial
increases expected in non-OPEC supply during the
year and with OPEC production already at much
higher levels than current demand, it is clear
we are fairly confident about the market outlook
for the year…We remain totally committed to
market stability, with prices at reasonable and
sustainable levels. We firmly recognize the
importance of a stable, orderly oil market to
world economic growth, long-term investment, and
the advancement of global prosperity.
Prices eased in February, falling
below $60 per barrel briefly before stabilizing
around $60-$63 per barrel, perhaps as a result
of crude inventory data showing stockpiles at
the highest level since May 1999. At its
March 8, 2006 meeting in
Vienna[31],
OPEC members agreed to maintain its current
production ceiling of 28 million barrels per
day. In its press release, OPEC indicated the
following:
Having reviewed the oil market outlook, the
Conference observed that world economic
performance remains strong. The Conference also
noted that, although all indicators show that
the market is fundamentally well-supplied with
crude oil and that commercial oil stocks in the
OECD are at high levels, world crude oil prices
remain volatile, these being driven by
geopolitical factors and associated concerns
regarding potential future supply disruptions,
as well as downstream bottlenecks, exacerbated
by more stringent US fuel quality standards.
These factors are reflected in the increased
activity observed in the futures market and the
pattern of disconnect between prices and
commercial stock levels, that has become
apparent since 2004.
By the end of the quarter, however,
prices had once again increased to around the
$66 level, perhaps as a result of the loss of
roughly 500,000 barrels per day in supply due to
militant attacks on the Nigerian oil
infrastructure.
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