Is the Consumer Taking a Breather? Housing Starts and Retail Sales say...maybe Econoday Focal Point 7/15/00 By Evelina Tainer, Chief Economist

Fed officials are waiting…and hoping
Over a period of 12 months, the Federal Reserve raised rates six times for a total of 175 basis points, bringing the federal funds rate target from 4.75 percent on June 29, 1999 to 6.50 on May 16. The first five rate hikes each tightened the screws by only one-quarter of a point. Economic activity didn’t exactly stop on a dime with any of the rate hikes. Indeed, real GDP continued on the same fast paced path into the first quarter. This forced the Fed to raise the funds rate target by 50 basis points in May. Market analysts often forget that several months typically elapse before a rate hike slows any of the interest rate sensitive sectors.

In June, several economic indicators finally began to show signs of moderation. Consequently, the Federal Open Market Committee left rates unchanged at their month-end meeting. Yet they still expressed concerns that heightened inflation risks remained.

In order for the most recent policy decision to be more than a pause, Fed officials will have to see some moderation in consumer demand. This means that housing demand as well as demand for consumer durables such as furniture and appliances will have to drift lower. Consumers tend to borrow to buy cars and trucks too, so higher interest rates might curtail spending on motor vehicle sales though this is sometimes muted by manufacturer incentives.

The stop-start housing market
Housing starts peaked in early 1999. In fact, activity started to moderate after the first quarter that year and it appeared that a slowdown was around the corner even before the Fed first raised rates in June 1999. However, the second half of 1999 and first quarter of 2000 showed a resurgence in the housing market. Much of the increased activity came in multi-family dwellings, a sector which often shows less reaction to higher rates. Instead, economists and government policymakers focus on single family housing construction to glean consumer demand. Note below that the pattern for single family units resembles that of total starts. And single family housing starts appear to be hitting a plateau. But since housing starts rebounded once before, it will take a few more months of data before Fed officials have faith that a downward trend is underway.

Rising interest rates…increasing mortgage rate spread
Mortgage rates began to rise last year even before the Fed began to tighten policy. The chart below depicts how the 30-year fixed mortgage rate is tied to the yield on the 10-year Treasury note. The spread between these two rates has widened in the past several months with the mortgage rate rising more rapidly than the 10-year note. This is due to the U.S. Treasury’s stated intention to reduce the total amount of new securities -- particularly long term (30-year) bonds. Less 30-year issues have increased the demand for 10-year notes in recent months as this Treasury security is rapidly becoming the new benchmark. In contrast, the rising mortgage rates are following the upward trend set by the federal funds rate target.

It is likely that the spread between the 10-year Treasury note and the 30-year fixed mortgage rate will remain at these new higher levels. Consumers shouldn’t expect mortgage rates to improve dramatically in the near term even if Treasury yields edge lower.

The chart below depicts the rapid growth in home sales over the past ten years relative to year-over-year changes in median home prices. Three-month moving averages are used to smooth these volatile monthly series. The peak-selling rate occurred in November 1998. Even after smoothing the data, the chart depicts fluctuating new home sales in the past eighteen months. Nevertheless, a downward trend is taking shape. It’s possible that rising home prices, in addition to higher mortgage rates, are having a dampening effect on demand for newly constructed homes.

Existing home sales have shown the same upward momentum in the past several years as have new homes. (Note that existing home sales were more stable than new home sales during the 1990-91 recession.) The affordability index compares median income to qualifying income for existing home sales taking into account home prices as well as mortgage rates. The affordability index has dropped sharply in the past 12 to 18 months. Except for a brief uptick in May, it appears that the drop in affordability since 1999 has caused a downward trend in existing home sales.

Retail Sales
A rising interest rate environment could impact retail spending in a variety of ways. In general, consumers may feel poorer because borrowing is simply more expensive and takes a bigger chunk of household income. Typically, higher interest rates will first impact interest-sensitive sectors such as auto sales, furniture sales and building materials. The chart below depicts yearly changes in total retail sales as well as retail sales excluding the volatile auto sector. Note that both are down from their highs.

How weaker housing impacts retail sales
When housing demand starts to shift down, so will spending on furniture and appliances. Generally, sales for home furnishings and appliances will start to slow about three to six months after the drop in home sales. Sales appear to have peaked at furniture stores in the early part of 2000. On a year-over-year basis, the downward drift has only just begun. Given the more moderate pace of housing, it is likely that spending for furniture and appliances will also decrease in coming months. Note that this spring was a rough time for retailers in general.

The drop in sales of building materials and hardware is somewhat more dramatic. Sales at stores that cater to builders (think Home Depot, Menard’s, Lowe’s) peaked early in 1999 and have moderated ever since. There is no question that at least some spending has been curtailed.

Spending on auto sales has dropped off since the peak in mid-1999. But keep in mind that the consumer love affair with their cars (sports utility vehicles or motorcycles) has not ended. It is simply downshifting from a record pace. Nonetheless, from an economic accounting perspective, a lower sales pace for cars and trucks does translate into declines in spending growth from one month to the next. The trick here is that auto dealers often offer incentives to spur sales and this may counteract some of the negative impact from higher borrowing rates.

Retail sales are currently hampered by high and rising gasoline prices. Prices surged last year and most economists had expected some of the gains to be offset this year as oil production was increased. However, production gains have been weaker than projected; at the same time, demand has remained strong. Prices simply have gone higher, rather than lower. Consumers are now facing dramatically higher gasoline bills. Anecdotal evidence suggests that this has curtailed spending on other goods and services – such as eating out and apparel sales.

THE BOTTOM LINE
Federal Reserve officials have long been concerned that the whopping growth in consumer spending on goods and services as well as in housing investment will lead to accelerating price pressures. They believe that a moderation in aggregate demand will go a long way in stemming the threat.

The Fed has already tightened monetary policy in the past year – enough to increase the "real" (inflation-adjusted) federal funds rate target. Policymakers realize that monetary policy may have relatively short implementation lags, but lags nevertheless exist between rate hikes and an economic cooling. In response to some moderation in economic indicators such as housing and retail sales, the Fed was willing to at least momentarily pause to see if past rate hikes would indeed hamper growth enough to cool down the economy to a long term sustainable rate.

Fed officials will be watching closely at the indicators discussed above to determine whether aggregate demand is finally moderating and inflationary pressures are relieved or whether they will have to raise rates again in coming months. Stay tuned.

Updated July 7, 2000