Moderating growth: while the collapse in the for-sale housing market weakened the economy, aggressive business investment and retreating energy prices give reason for optimism.

By the close of 2006, forces were combining to slow the economy. Affordability and increases in mortgage interest rates and the overhang from loose underwriting policies of many mortgage lenders produced the current collapse of the for-sale housing markets.

New for-sale home building and existing home sales activity have declined and constitute a weak point in the economy.

Also, equity obtained from mortgage refinancing and sales of existing homes have been an important source of cash for home improvement expenditures and other consumer outlays, and this source is diminishing as housing prices fall.

There are also reasons to be optimistic. The Federal Reserve Board (the Fed) probably will not significantly tighten monetary policy in 2007. Economic growth and record business profits helped reduce the federal budget deficit. Businesses, experiencing increasing sales and profits, will invest more aggressively.

GDP growth over the second and third quarters of 2006 dropped markedly. Energy prices have retreated, which should add to potential economic activity. Real GDP is forecasted to increase by 2.8 percent in 2007 after rising an estimated 3.1 percent in 2006.

Underlying Fundamentals

Labor Market. Labor market performance improved to annual rates of growth of over 2 million jobs in 2005 and through the first quarter of 2006, in the survey of employers. The labor market has eased since then to a rate under 1.9 million. This is still strong.

The unemployment rate, based on a survey of households, dropped to 4.4 percent, the lowest level in more than five years.

Slower economic growth and the decay in single-family housing construction and existing home sales will impact the employment increases. Non-farm employment should grow by 1.5 million jobs in 2007.

Inflation. Inflation is back under control now that oil prices have retreated from the sharp upturn earlier in 2006.

The yearly average for consumer price inflation (CPI) for 2006 was about 3.4 percent (measured on a December to December basis), and matched the rate for 2005.

This is the second consecutive year that the CPI has risen less than 2.5 percent. A slower economy and moderation in job creation should permit consumer inflation to drop to 2.2 percent.

The GDP deflator, a broader measure of inflation, rose 3 percent in 2006, the same as a year before. Its rate of increase should moderate slightly to 2.8 percent in 2007.

Federal Funds Rate. The Fed ended a string of 21 increases in the Federal Funds Rate in its August 2006 meeting.

The Federal Funds Rate is the interest rate at which banks lend their balances at the Federal Reserve to other banks on an overnight basis. The increase brought the rate to 5.25 percent in June 2006, up from 1 percent in June 2004.

Slowing of the economy and stable core inflation (changes in consumer prices less food and energy) ended the Fed's tightening monetary policy. It is still concerned about the potential for increased inflation and will raise rates if core inflation rises. It is most likely that inflationary pressures will be modest if productivity gains resume, and little change can be expected in 2007. Short-term rates may even decline slightly as the economy eases. Long-term rates will increase by an average of only about 20 basis ***** points (100 basis points equals 1 percent) in 2007 and will drop at times during the year.

Productivity. Productivity was a major positive force in the economy from 1996 until the spring of this year. Its strong growth helped keep inflation low.

Non-farm business productivity grew at an average annual rate of 2.8 percent over the period. Productivity growth, while strong, moderated from 2003 to 2005, and this year it has slowed dramatically and was unchanged in the third quarter of 2006.

Unit labor costs are more concerning, having risen in 2006 at the fastest pace since 1990. This raises serious concerns about inflationary wage pressures. The marked growth in unit labor costs could lead the Fed back to tightening its monetary policy, despite the slowing in the economy.

It is likely, however, that productivity growth will rebound to about 2 percent in 2007 as the economic expansion matures and businesses find it more difficult to squeeze more out of existing workers.

Personal Consumption

Consumers were the most consistent positive force in the economy over the past several years. That is important because their spending accounts for more than two-thirds of the GDR 

Growth in consumption has eased in 2006 and is expected to be 3.1 percent versus 3.5 percent in 2005. Consumer confidence has improved because oil prices retreated from the sharp summer run-ups.

Other principal drivers of confidence are mixed. Labor markets are tight, but employment increases have slowed because of weakness in housing markets, and unemployment has leveled and may rise. Consumer durable spending growth is moderating sharply as auto buying falls. Adding to consumer problems are record levels of consumer debt. Growth in wages is higher than it was since the spring of this year, and along with lower energy prices, the growth helps to offset somewhat the weaker factors.

[GRAPHICS OMITTED]

The outlook for consumer spending shows slower growth in 2007 with a 2.7 increase. Higher than forecasted GDP growth in 2007 will have to come mostly from stronger consumption spending, which is unlikely.

Investment

Gross private domestic investment (GPDI) has been a significant force in overall economic growth since 2004. Residential investment (new construction and improvements) was the real star with an average annual rate of growth at approximately 9 percent that actually started in 2003 and lasted through 2005.

The for-sale housing construction boom came to an end this year and is still weakening. Non-residential investment (buildings and equipment and software) joined in with a lag, but with components performing somewhat differently.

Residential Investment. Residential investment jumped between 2003 and 2005 with stimulative monetary policy leading the way to produce 40-year lows in mortgage interest rates. For-sale housing construction and improvements thrived. Single-family home starts reached record levels and multifamily condo construction boomed. Housing prices soared and affordability of for-sale housing was aggravated by higher mortgage interest rates. The correction in the for-sale housing market continues to deepen and new construction will fall further.

Residential remodeling improvement expenditures, part of the residential investment category, also have been strong in this decade. Declines in home values along with fewer home sales should combine to produce an easing in demand for "big ticket" remodeling and projects.

Non-Residential Investment. Non-residential fixed investment has risen at a faster pace each year since 2003. Prior to 2003 it had been constrained by recessions in most nonresidential sectors and the technology bust.

The non-residential structures construction sector recovery was quite modest until 2006 with less than 2 percent growth in 2004 and 2005. Then in 2006, it rose at a near double-digit rate. Sharply increased travel over the past two years has helped revive hotel and motel construction. The U.S. Department of Commerce reported that hotel and motel construction was up 48 percent over the first three quarters of 2006.

The second largest growth center in 2006 was amusement structures with a 21 percent increase. Casino hotels, which may be recorded in the Commerce Department hotel or amusement sectors, spurted, with Las Vegas and Atlantic City starting several major projects in 2006, according to McGraw-Hill Construction. Most other commercial construction sectors experienced double-digit growth in 2006. Non-residential structure investment should rise by 12 percent in 2007, the highest growth rate of all sectors.

Business Investment. Investment in business equipment and software moderated slightly in 2006 to a still-strong 7 percent growth from an 8 percent average in 2004 and 2005. Much of the growth in business investment over the past three years has been in computers and peripheral equipment, which is still recovering from the tech bust. Purchases of computers and peripheral equipment grew at an annual rate of over 18 percent in 2005 and 2006. Their recent growth rate is near the 20 percent plus levels experienced during the tech boom of the second half of the 1990s. Some moderation in computers and peripheral equipment is expected next year as the economy continues to cool. Software expenditures by businesses are good, but their rate of growth is moderating as the economy softens.

Business inventories (a part of domestic investment) has risen more intensely in 2006 as the economic growth rate has slowed. Some moderation in the rate of inventory accumulation by businesses should occur in 2007.

The outlook for gross private domestic investment calls for 3 percent growth in 2007, down from about 6 percent in 2005.

International Trade and Government Contribution

A return to declines in the value of the dollar and the sharp drop in oil prices should help to improve U.S. exports. The expected improvement in the economy should be enough to raise exports faster than growth in imports and limit the deteriorating U.S. trade balance in goods and services. There is a possibility that the trade deficit will be smaller in 2007.

Government spending increases that contribute to GDP (consumption expenses and gross investment) have been modest over the past three years. Their growth rate in inflation-adjusted terms has been less than 2 percent annually. Federal spending growth over the last two years has slowed after the sharp run-ups related to the wars in the Middle East and Homeland Security costs. State and local government spending rose an estimated 2.1 percent in 2006 after increasing only 0.5 percent or less in each of the three previous years. It is expected that government spending will continue to grow more slowly than the overall economy in 2007.

2007 Rental Housing Forecast: Improvements Continue

BY ROBERT J. SHEEHAN

Improvement in the rental housing market will continue into 2007. Rent increases are more positive and rental vacancy rates have dropped. Longer-term demographic trends favor rental demand over the next several years. Most important is that renters shares of households appear to have bottomed.

[GRAPHIC OMITTED]

Net Effective Rent Increases. Net Effective Rent increases have risen from a 3 percent annual rate in January 2006 to a 3.9 percent rate in September and are rising faster than overall consumer prices. They should be up by 3.5 percent in December from a year earlier and will increase by 3.7 percent in 2007.

[GRAPHIC OMITTED]

Vacancy Rates Improve Slightly. Rental apartment vacancy rates returned to double digits during the first three quarters of 2006 after dropping to 9.5 percent in the fourth quarter of 2005 in the U.S. Census Bureau data series for all rental apartment units.

That is in contrast to the 0.5 percent decline to about 5.5 percent in privately collected data series for professionally managed market rent properties in major metropolitan areas. Traditionally, there are significant differences in the levels of apartment vacancies in the two types of data series, but the relative trend directions tend to be similar. Performance in the labor markets, the weakening of the for-sale housing market and rates of increases in rents supports a trend of lower vacancy rates. Softening in expected economic and employment growth will limit the rate of improvement in vacancy rates during the forecast period, but occupancies will still increase.

[GRAPHIC OMITTED]

Renter's Share to Rise. The trend of sharp increases in the homeownership rates has ended. The renter's share of households in 2006 did not improve as it had in 2005. The weakened for-sale housing market and affordability issues from the sharp run-up in housing prices will combine to increase rental unit demand and the renter's share of households will rise. More favorable demographics for the rental market are occurring and will produce increased renter's shares of households in the longer run.

[GRAPHIC OMITTED]

Demographics Drive Growth. Improvement in the apartment market has been aided by shifting demographic forces. Household growth has improved dramatically since the 2001 recession, but it has showed signs of slowing slightly since spring 2006. Growth in households from the same month in the previous year fell from a 1.6 million average over last winter and spring to a 1.2 million rate since then. Housing affordability and some easing in employment increases has produced the slowing of household growth. The weakness in the for-sale housing market and high home prices in spite of recent declines will help the rental housing market.

Also contributing to rental housing demand is the increasing number of young adult Echo Baby Boomers that will continue into the next decade. About 2.1 million more households 25 to 34 years of age should exist in 2015 than exist currently according to a forecast by the Harvard/MIT Joint Center for Housing Studies.

[GRAPHIC OMITTED]

Multifamily Construction to Drop. Multifamily construction has been relatively stable for the past several years with a range of 328,000 to 347,000 units.

A slight drop to a 343,000 unit count is expected for 2006. Significant changes, though, have occurred within the multifamily construction sector. Rental unit starts have declined over the past four years while condo/co-op jumped from 72,000 units in 2002 to an estimated 160,000 for 2006.

Total multifamily construction in 2007 is expected to drop 4 percent to 328,000 units. The change in the mix of types of multifamily units started will be more dramatic. Rental construction should resume growth and rise about 8 percent while condo/co-op starts decline 18 percent. Condo/co-op starts will fall as a significant correction that started in mid 2006 continues. The adjustment in condo/co-op starts was inevitable. Speculation had become rampant. Rental unit construction will improve in response to a cooling of the for-sale market and a relatively strong labor market.

Top 7 Economic Trends

1. Improving Labor Market Performance. Non-farm employment should grow by 1.5 million jobs in 2007.

2. Inflation Under Control. Inflation's rate of increase should moderate slightly to 2.8 percent in 2007.

3. An End to Tightening Monetary Policy. Long-term rates will increase by an average of only about 20 basis points (100 basis points equals 1 percent) in 2007 and will drop at times over the year.

4. Rebounding Productivity. Productivity growth will rebound to about 2 percent in 2007 as the economic expansion matures and businesses find it more difficult to squeeze more out of existing workers.

5. Slower Personal Consumption Growth. The outlook for consumer spending shows slower growth in 2007 with a 2.7 increase.

6. Residential Investment Correction. The correction in the for-sale housing market continues to deepen and new construction will fall further.

7. Non-Residential Investment a Hot Sector. Non-residential structure investment should rise by 12 percent in 2007, the highest growth rate of all sectors.

Robert J. Sheehan is NAA's consulting economist. He can be reached at 703/471-9339 or [e-mail].