When Will Real Estate Recover?

The Mortgage Corner

Ah, that is the $64,000 question we have been asking since 2008, when housing imploded. Where are conditions improving, if anywhere? The Fed announced it would continue to hold down interest rates, and loan modifications are helping to cut into the foreclosure inventory, which has declined slightly from its highs.

The S&PCase-Shiller same-home price index, the best measure of price changes, rose in 19 of its 20 metropolitan areas in May, with San Francisco,San Diego, Minneapolis, and Los Angeles most improved. Prices in its 10-city index rose 5.4 percent, and 4.6 percent in its 20-city index. But in spite of 3 consecutive monthly increases, S&P said prices were still moving sideways—which probably means they expect prices to decline in June and July after expiration of the tax credit deadline.

Prices have stabilized, in other words, but consumers are not yet convinced that the jobs picture will improve. So consumers continue to pay down mostly mortgage debt, says a New York Fed quarterly report on household debt and credit.

“Aggregate consumer debt continued to decline in the second quarter, continuing its trend of the previous six quarters,” said the report. “As of June 30, 2010, total consumer indebtedness was $11.7 trillion, a reduction of 6.7 percent from its peak level at the close of 2008Q3. Excluding mortgage and HELOC balances, consumer indebtedness fell 1.5 percent in the quarter and, after having fallen for six consecutive quarters, stands 8.4 percent below its 2008Q4 peak."

This has not helped new and existing-home sales, also recovering from expiration of the first-time homebuyer’s tax credit. Existing-home sales, which are completed transactions that include single-family, townhomes, condominiums and co-ops, dropped 27.2 percent to a seasonally adjusted annual rate of 3.83 million units in July from a downwardly revised 5.26 million in June, and are 25.5 percent below the 5.14 million-unit level in July 2009.

Sales are at the lowest level since the total existing-home sales series launched in 1999, and single family sales – accounting for the bulk of transactions – are at the lowest level since May of 1995, but actual totals are still lower than one year ago.

To put that number in perspective, according to the NAR, existing-home inventories increased to 3.98 million units in July from 3.89 million in June, piling up because of the lower sales rate. But the all time record high was 4.58 million homes for sale in July 2008, so inventories have actually declined 1.9 percent year-over-year. Inventory is therefore very much dependent on the sales’ rate.

So there are some signs of improvement. The latest Federal Reserve survey of Senior Loan Officers also indicated an easing of credit requirements for both residential and commercial loans over the past quarter, the first easing since 2008.

And delinquency rates are declining, according to the Q2 Mortgage Banker’s Association report. The seasonally adjusted delinquency rate stood at 5.98 percent for prime fixed loans (which make up some 60 plus of outstanding loans), 13.75 percent for prime ARM loans, 25.19 percent for subprime fixed loans, 29.50 percent for subprime ARM loans, 13.29 percent for FHA loans, and 7.79 percent for VA loans.

What is obvious is that the percentage of 90 day-late payments and foreclosures is increasing as a share of total delinquencies as lenders speed up the process of modifications and foreclosures to get delinquent loans off their books. The percentage of loans on which foreclosure actions were started during the second quarter was 1.11 percent, down 12 basis points (0.12 percent) from last quarter and down 25 basis points from one year ago.

The delinquency rate includes loans that are at least one payment past due but does not include loans in the process of foreclosure.  The percentage of loans in the foreclosure process at the end of the second quarter was 4.57 percent, a decrease of six basis points from the first quarter of 2010, but an increase of 27 basis points from one year ago.

“Consumers rationally jumped into the market before the deadline for the home buyer tax credit expired, said NAR economist Lawrence Yun. “Since May, after the deadline, contract signings have been notably lower and a pause period for home sales is likely to last through September,” he said. Even with sales pausing for a few months, annual sales are expected to reach 5 million in 2010 because of healthy activity in the first half of the year. To place in perspective, annual sales averaged 4.9 million in the past 20 years, and 4.4 million over the past 30 years,” Yun said.

Since sales’ statistics are notoriously imprecise (with ± 15 percent error), we can say that real estate sales have been treading water after an initial sales spurt in 2009, though existing-home prices actually increased 0.7 percent in July, indicating that expiration of the tax credits caused most of the sales’ decline in the lower-end of the market.

The bottom line is that banks seem to be finally committed to cleaning the bad loans off their books. This will probably keep prices from rising in the short term. But it will also enable them to reduce their loan loss reserves and so ease credit conditions for home buyers further, thus reducing inventories and boosting sales further.

Harlan Green © 2010

Beware of Extraordinary Times

Popular Economics Weekly

Yes, Beware of Extraordinary Times is a much used saying these days.  It also applies to the extraordinary polarization of ideas in the economics profession at present. This is an election year, of course, which has distorted the debate on economic recovery.

We know that debt is bad, for instance, but borrowed debt is worse, says Alan Greenspan. So allowing some of the Bush-era tax cuts to expire may be a good thing, since those tax cuts reduced revenues while increasing the budget deficit. And the truism that one has to spend money to make money applies to government as well as the private sector. The just-ended Great Recession required government to borrow huge sums of money to make money—i.e., just to keep the U.S. economy afloat.

Government stepped in because the private sector downsized, shedding more than 8 million workers and shutting down whole sectors of the economy—both small businesses and large, from autos to airlines.

So it should be a no-brainer that government and the private sector need to find better ways to work together, rather than participating in the demonization that has caused such an extraordinary polarization of ideas—all government is inept, for instance, and all capitalists selfish and greedy. One area that both sectors should agree on is how to stimulate the demand that grows an economy. And right now there is little agreement on how to simulate economic growth.

Conservatives maintain we must pay down debt, and decrease government spending to stimulate economic growth—private business lives in eternal fear of debt and so won’t choose to expand when they worry about higher debts and future inflation, they say. While so-called liberals (who were at one time Eisenhower Republicans) believe that without government intervention during recessionary times, economies will stagnate and unemployment remain unacceptably high.

But in fact both government and the private sector are a part of what is called aggregate demand, the demand that stimulates economic growth. It is a relatively simple formula:

Where aggregate demand is AD,

• is Investment,
• is Government spending,
• is Net export,
  • is total exports, and
  • is total imports = a_m + b_m(Y − T).

Notice there is no mention of debt in the formula. Our Gross Domestic Product is its closest approximation, and the classical definition of a recession/depression is when GDP shrinks for at least 2 quarters. It shrank more than 4 quarters during this Great Recession, which is the main reason these are such extraordinary economic times.

The fact that we are fighting two wars with borrowed money, while recovering from a credit crisis and housing bubble that resulted from too much borrowed money, means that extraordinary measures are required. We must bury the hatchet between government and the private sector—doing nothing is not an option.

Historical hindsight tell us it was too little government regulation—both due to outmoded laws and lax oversight—and a private sector obsessed with profit over prudence that caused the Great Recession.

This has resulted in some $6 trillion in lost output of GDP, which could have been worse, if government had not come to the rescue.

Zero interest rates are scary during ordinary times, certainly. It is scary to savers and lenders, because it reduces their incomes. And it is scary to consumers because it signals falling prices, with lead to falling wages and fewer jobs.

But unless said aggregate demand begins to grow again, stagnation will continue. At present there is very uncertain growth, mainly because banks, investors and corporations are hoarding their assets. Corporations are hoarding their cash from a decade of record double-digit profits, investors from their stock and bond losses, banks because they are reluctant to lend until their capital base has been restored, while consumers continue to restore their wealth and wait for businesses to hire again.

It has been left to government to provide some stimulus during these times to satisfy the most basic human needs of shelter and food, by borrowing from the almost $1 trillion in excess bank reserves held by the Federal Reserve (that banks are not using) and $1.8 trillion in cash that corporations are hoarding.

In other words, when I + C + X-M falters, then the G of government has to provide the stimulus. That was the lesson of the Great Depression. It began in 1929 when the Hoover Administration’s tightened credit to combat inflation, and lasted until 1933 when Roosevelt instituted the modern government safety net—including social security, unemployment insurance, and the various government work projects that directly employed millions of the young and old.

The key is to find ways to unlock that demand. It makes sense that since consumers make up some 70 percent of economic activity at present, putting more money into consumers’ pockets is a must. But if in the form of tax breaks, it must flow to those in the lower income brackets, where it gets spent. Most of the tax benefits to date have gone to the upper 1 percent in the form of investor benefits—such as lower capital gains and dividends taxes—i.e., to the investor class who tend to save rather than spend most of their income.

Another remedy is bond trader Bill Gross’s suggestion of spending more on infrastructure. California is building its first high-speed rail service with federal stimulus money. This would employ more blue-collar construction workers who have been hardest-hit by this recession.

Also, homeownership is down from 70 percent to approximately 66 percent of households, with somewhere between 5 to 10 million of those households’ loans in danger of default, government can do more to support housing. Roosevelt during the 1930s actually took ownership of homes and rented them back to former homeowners, until they were able to buy them back. Today’s various loan modification programs are pale imitations of what was done then.

Yet government can only do so much to stimulate growth. The private sector must step up and find ways to stimulate greater demand for its products. Madison Avenue has always found ways to stimulate both wanted and unwanted consumer needs that result in an excess of choices. With corporations once again making record profits, there is no reason for them to resist hiring more workers. Labor productivity is at record highs because corporation continue to push their existing workforce to produce more.

That should also be the lesson of the Great Recession. Extraordinary times call for extraordinary measures.

Harlan Green © 2010

Housing Affordability Still at Highs

The Mortgage Corner

Bolstered by favorable interest rates and low house prices, housing affordability remained near its highest level nationwide for the sixth consecutive month since the series was first compiled nearly two decades ago, according to the National Association of Home Builders/Wells Fargo Housing Opportunity Index (HOI) released today. And both housing construction and new-home sales are beginning to rise again after a lull.

The HOI indicated that 72.3 percent of all new and existing homes sold in the second quarter of 2010 were affordable to families earning the national median income of $64,400. The index for the second quarter was slightly more affordable than the previous quarter and almost equaled the record-high 72.5 percent set during the first quarter of 2009. Until 2009, the HOI rarely topped 67 percent and never reached 70 percent.

“Homeownership is within reach of more households than it has been for almost a generation,” said NAHB Chairman Bob Jones. “Interest rates continue to hover at historic low levels, the economy is beginning to rebound and with house prices starting to stabilize, conditions are beginning to draw home buyers back into the market, which is a positive step on the path to recovery.”

Syracuse, N.Y., was the most affordable major housing market in the country, edging out Indianapolis-Carmel, Ind., which had held the top ranking for nearly five years. In Syracuse, 97.2 percent of all homes sold were affordable to households earning the area’s median family income of $64,300.

Housing starts also posted a modest comeback in July, rising 1.7 percent after an 8.7 percent decrease in June. The July annualized pace of 0.546 million units came in below the median forecast for 0.565 million units and is down 7.0 percent on a year-ago basis.

The July improvement was led by a 32.6 percent bounce back in multifamily starts, following a 33.3 percent drop in June, as more households become renters. The single-family component is still weighed down by inventories-declining 4.2 percent after dipping 1.7 percent in June.

By region, the gain in starts was led by a 3.9 percent rebound in the South. Other regions declined-the Northeast, down 25.9 percent; the West, down 4.9 percent; and the Midwest, down 1.1 percent.

New-home sales also recovered form recent lows. The June pace recovered to an annualized 330,000 from a revised 267,000 for May and revised 422,000 for April. While the comeback is welcome, the bad news is that May's record drop was revised down notably from the initial estimate of a 33.0 percent decline. The latest figure is down 16.7 percent on a year-ago basis.

Monthly supply has seen sharp movement in recent months as that ratio is moved more by sales than by the number of homes on the market. Supply on the market eased somewhat to 7.6 months after surging to 9.6 in May. April had been pushed down to 6.1 months' supply as sales bumped up to meet the signing deadline for tax credits. The median home price slipped 1.4 percent to $213,400. Year-on-year, the median price in June is down 0.6 percent. The bottom line is that the elevated inventory levels of new homes is helping keep prices low.

Another interesting statistic put out by Calculated Risk is the distribution of mortgage interest among homeowners.

A just released Census Bureau housing survey showed:

· 76.4 million owner occupied housing units in 2009.

· 24.2 million were owned free and clear (no mortgage). That is 31.7 percent.

· 26.8 million primary mortgages were originated in 2004 or earlier.

· 12.7 million primary mortgages were originated prior to 2000.

· 24.1 million primary mortgage had interest rates above 6 percent.

This is while the 30-year conforming fixed-rate mortgage averaged 4.42 percent for the week ending Aug. 19, a record low since Freddie started tracking the rate in 1971. And, there are at least 10.9 million homeowners with 2nd mortgages and another 800 thousand the 3 or more mortgages.

This all means that the new affordability is not available to everyone. Only 6.2 million of primary mortgages were under 5 percent (as of 2009). This will increase in 2010, but quite a few homeowners had primary mortgage interest rates above 6 percent. And the U.S Bureau of Economic Analysis recently reported that the effective rate on all mortgages was still above 6 percent in Q2.

Harlan Green © 2010

Jobs Remain on Hold

Popular Economics Weekly

Employers are not hiring at the moment. This doesn’t mean double dip that some economists are talking about, however. A pause in activity is normal during economic recoveries, as Alan Greenspan and others have commented recently.

Initial weekly claims for unemployment that track those applying for unemployment insurance is the best indicator of present job conditions. It has remained stagnant since January, though claims have been rising of late.

Initial claims for unemployment insurance are piling up, indicating that businesses are continuing to cut costs. Initial claims came in at 500,000 in the August 14 week for the largest total since November. The four-week average of 482,500 is the largest since December. A month-to-month look shows significant deterioration of 25,000 for a percentage change of nearly six percent.

But this is in part because all those Census workers the government hired have finished their work. And continuing claims continue down—13,000 in data for the August 7 week. The four-week average of 4.527 million is the lowest of the recovery.

July’s industrial production report was also positive. Manufacturing - which has been a key source of strength for the recovery but faltered in June – showed significant resurgence in July. Overall industrial production in July jumped 1.0 percent, following a revised 0.1 percent down tick in June.

By components, manufacturing posted a 1.1 percent comeback, following a 0.5 percent decline in June. The boost was broad-based as manufacturing excluding motor vehicles increased 0.6 percent, following a 0.3 percent dip the month before. Rounding out industry group components for July, utilities output was up 0.1 percent while mining advanced 0.9 percent.

And so-called capacity utilization jumped to 74.8 percent in July from 74.1 percent the prior month. This is still far below the long term 82 percent capacity utilization average, indicating lots of excess facilities, which is why companies are not investing in new plants—and so doing much hiring.

Lastly, retail sales are still slightly positive. What are now being called ‘cautious’, and ‘discriminating’ shoppers have been saving while spending for the near term only.

Overall retail sales in July rebounded 0.4 percent, following a 0.3 percent decrease in June.  A large part of the strength came from the auto component.  Excluding autos, sales gained 0.2 percent, following a 0.1 percent downtick in June.  The boost in auto sales is a positive, as is the other source of strength - a spike in gasoline sales likely lifted by higher prices.

Without the jump in gasoline sales, consumer spending was soft. But higher gas sales means consumers are driving more, a good sign. Sales excluding autos and gasoline slipped 0.1 percent, following a 0.2 percent boost in June. By components, the rebound in July was led by a 1.6 percent boost in motor vehicle sales and a 2.3 percent jump in gasoline station sales. Also showing gains were miscellaneous stores, nonstore retailers, and food services & drinking places.

Need we say more? None of the indicators show a real decline in demand, rather a pause as both consumers and employers remain cautious about future economic activity, and the jobs outlook.

Harlan Green © 2010

Fed does more “Quantitative Easing”

Popular Economics Weekly

In spite of Fed Chairman Bernanke’s recent optimism about avoidance of a double-dip recession, the Federal Open Market Committee announced they would continue to purchase Treasury Bonds, rather than allow the $2.05 trillion they now hold on their balance sheet to shrink as they are paid off. This allows more money to remain in circulation. Why? Probably to counter increasing consumer pessimism.

Their FOMC statement released after the meeting said as much. The statement acknowledged "that the pace of recovery in output and employment has slowed in recent months." This was less positive than in their June statement "that the economic recovery is proceeding and that the labor market is improving gradually."

Why the increased pessimism? The Conference Board’s confidence index has been stagnant since May 2009 over worries about the jobs picture and income prospects. The overall consumer confidence index slipped to 50.4 in July from an upwardly revised 54.3 in June. The latest decrease was led by a drop in expectations to 66.6 from 72.7 in June. This puts the index back to April 2009 levels.

Bernanke highlighted growing strength in the consumer sector, as we said last week. “In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions.”

One reason the Fed has become alarmed is that forward momentum for the consumer sector stalled in June as personal income was unchanged, following a 0.3 percent boost the month before and retail sales slipped.  What supports consumer spending fared even worse. The wages & salaries component slipped 0.1 percent after posting a healthy 0.4 percent advance in May.

Most of the weakness came from goods-producing industries' payrolls which decreased $8.9 billion of which $6.0 billion was in manufacturing.  Services-producing industries' payrolls increased $3.7 billion. The decline in the number of temporary workers for Census 2010 subtracted $3.4 billion at an annual rate from federal civilian payrolls in June.

But the latest Institute for Supply Management Indexes actually look better. The ISM's July non-manufacturing composite index in particular improved to 54.3 from 53.8 month before.  Business activity, akin to a production index, edged slightly lower to a still very strong 57.4 – well above breakeven of 50. But forward momentum may be gaining as the new orders index rose nearly 2-1/2 points to 56.7.  Also, employment advanced more than one point to 50.9 for its best reading of the recovery.

Despite the negative headline number, there were some notable positives in the latest employment report – all pointing toward improvement in income.  Average hourly earnings improved to up 0.2 percent, following no change in June.  The average workweek for all workers rose to 34.2 hours from 34.1 hours in June.  The firming in the workweek could be an early indicator of additional hiring down the road.

Probably the biggest positive in the report is a 0.6 percent jump in aggregate weekly earnings after dipping 0.3 percent in June.  This points to a healthy gain in the wages & salaries component of personal income in coming weeks. And so these reports probably provide the best current argument - outside of private payroll job gains – that the economy is not headed for a double dip recession.

Harlan Green © 2010

What is the ‘New Normal’—Part II?

Popular Economics Weekly

Fed Chairman Ben Bernanke is sounding more optimistic these days. What is behind his optimism that seems to counteract the “New Normal” predictions of bond traders such as PIMCO and other fiscal conservatives who fear massive debts will hurt growth and fuel increasing inflation?  Bernanke feels that domestic economic activity is bound to pick up with a worldwide pickup, as Asia and Europe slowly recover from their malaise.

Chairman Ben gave his most recent speech to southern legislators in South Carolina. “After a precipitous decline in late 2008 and early 2009, the U.S. economy stabilized in the middle of last year and is now expanding at a moderate pace. While the support to economic activity from stimulative fiscal policies and firms' restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth.”

Third quarter Gross Domestic Growth was 2.4 percent—good but not great enough to bring down the unemployment rate, which is stuck at 9.5 percent.

Domestic demand is the basic driver of growth — consumer spending, business fixed investment, housing investment, and government purchases. Real final sales to domestic purchasers rose a very positive 4.1 percent, compared to a 1.3 percent gain in the first quarter. Basically, demand by said U.S. consumers, businesses, and the government was up significantly in the second quarter.

Bernanke highlights growing strength in the consumer sector, which powers almost 70 percent of economic growth. This showed up in an 18 percent rise in imports, mostly from consumer purchases. “In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment. At the same time, rising U.S. exports, reflecting the expansion of the global economy and the recovery of world trade, have helped foster growth in the U.S. manufacturing sector.”

The biggest surprise was the growth in commercial and residential investments. Real nonresidential (i.e., commercial) fixed investment increased 17.0 percent in the second quarter, compared with an increase of 7.8 percent in the first. Nonresidential structures increased 5.2 percent, in contrast to a decrease of 17.8 percent. Equipment and software increased 21.9 percent, compared with an increase of 20.4 percent. Real residential fixed investment increased 27.9 percent, in contrast to a decrease of 12.3 percent.

July total nonfarm payroll employment did not so well, declining by 131,000 and the unemployment rate was unchanged at 9.5 percent, said U.S. Bureau of Labor Statistics. This was mainly because federal government employment fell, as 143,000 temporary workers hired for the decennial census completed their work. The good news was that private-sector payroll employment edged up 71,000, seasonally adjusted. e

What is now happening is that consumers are saving much more, as the Q2 preliminary savings rate shot up to 6.4 percent. This is in part due to the drop in spending, but also because consumers continue to pay down their debts.

Consumer credit contracted again in June, this time by $1.3 billion. If there is good news it's that the level of contraction is less severe than prior months. Also good news is an upward revision to May which now shows a $5.3 billion contraction vs. the initial contraction of $9.1 billion. Nonrevolving credit offers some good news, up $3.2 billion on top of May's increase of $1.8 (revised from a $6.5 billion contraction). Solid unit vehicle sales in July point to possible gains for this component in the next report.

All the talk about the ‘new normal’ may have a useful purpose. It is making policy makers aware of a possible need for a more comprehensive social safety net to provide for the millions who have been out work for the longest stretch since the Great Depression.

Even stalwart Republicans, like Bush economic advisor Glenn Hubbard believes government should boost educational opportunities for workers whose jobs are never coming back, said the New York Times. “If there is a new normal, it’s more about the labor market than G.D.P,” said Hubbard.

And PIMCO’s Bill Gross, also a fiscal conservative, is now advocating an expanded role for government to spend tens of billions on new infrastructure projects to put people to work and stimulate demand. He said, “We think the coma will last for years unless government policy changes to restimulate the private sector and bring unemployment down”.

Harlan Green © 2010

What is the ‘New Normal’?

Popular Economics Weekly

There has been much talk of late about the “new normal” of slower economic growth that we may see in coming decades. It is defined by bond trader PIMCO’s Bill Gross as what he calls declining global aggregate demand—the declining demand of consumers, businesses, and government for additional good and services. We have lived through an excess of consumption and debt, and must now pay for it, in other words.

“Developed nation consumers are maxed out because of too much debt, and developing nations don’t trust themselves to stretch their necks for the delicious leaves of domestic consumption just above,” he said in his current economic outlook.

How true is this? He might be correct for the short term—ten million jobs have to be created to replace those lost in just the past 2 years—but not about future growth. What is true is that we will have to live with less indebtedness. But substantial growth is continuing in new industries and developing nations—Brazil, India and China are the 3 fastest growing major nations in the world.

Consumers have been the first to pay down their debts, while businesses haven’t had to borrow much because of huge cash flows during the last decade that enabled them to finance their own operations without borrowing—and what little expansion there has been. So huge amounts of cash are sitting on the sidelines, which positions those with good ideas to expand rapidly.

Government will have to begin to size down as well, once this recovery picks up and the wars on terror have been resolved. This means consumers will be more selective in what they buy, and businesses more selective in who they hire. A recent New York Times article documented the ways industries have been able to achieve record profits (up 40 percent from late 2008 to Q1 2010), without much hiring.

This has resulted in profits rising much faster than revenues. Among the 175 companies in the S&P 500 that have already reported earnings last quarter, reported the NY Times, revenues averaged a 6.9 percent increase, while profits rose 42.3 percent.

How so? Firstly, productivity is rising faster than wages and salaries. Companies are investing more in technologies than workers, in other words. Year-on-year, productivity advanced 6.1 percent in the first quarter-up from 5.6 percent in the prior quarter. And unit labor costs—both wages and benefits—declined another 4.2 percent, compared to minus 5.1 percent the previous quarter. Output growth was a whopping 4.0 percent annualized, in other words, while hours worked barely budged up to 1.1 percent.

This is while personal income growth is barely rising. It grew just 1.6 percent in May, easing from 2.6 percent in April. Inflation was mixed in May. The headline PCE price index was flat as was also the case the prior month. The core rate, however, firmed to 0.2 percent from 0.1 percent in April.

The result is a basic disparity between income brackets, with the top 10 percent of incomes rising, and the majority of wager and salary earners with no income growth at all.  This is probably the main reason for the ‘new normal’.  Something that New York Times’ columnist Bob Herbert highlighted recently. 

A Yale study showed that more than 20 percent of Americans experienced a 25 percent or more loss in household income without any financial cushion from 1985-95, the highest in 25 years.  This is with our unemployment rate hovering around 9.7 percent. So many more than just the unemployed are suffering from the effects of the Great Recession.  But an income shift is occurring that should aid consumers, and shorten the era of falling incomes of the new normal—expiration of some of the most inequitable Bush II era tax breaks, and restoration of the taxable rates that helped to create a budget surplus during the Clinton era. 

Harlan Green © 2010

What is Pent-up Demand?

Financial FQs

We are now hearing that pent up demand is growing as the economic recovery takes its time. What is it, and what would it mean for an earlier recovery? Fed Chairman Bernanke mentioned that ‘demand’ could grow in a recent speech to South Carolina’s legislators.

“While the support to economic activity from stimulative fiscal policies and firms' restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth…In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment.”

Demand usually refers to aggregate demand, a key concept of Keynesian economic theory. The theory being that if consumers, businesses and governments have growing incomes/revenues, then their ‘demand’ for more goods and services will increase. Pent-up demand is comprised of the elements that must grow to stimulate aggregate demand.  This might seem obvious to anyone who has taken Economics 101, but how to measure aggregate demand is not so obvious.

We know several factors that can stimulate demand. For instance, the 2010 Harvard Joint Housing Taskforce Study estimates that 15 million new households will be formed over the next decade, including immigrants. Yet new home growth has slowed drastically. And there are maybe 1 million surplus existing homes, due to the housing collapse. Yet even with the overhang, the demand for housing is bound to grow exponentially over the next decade.

New home sales in June actually rebounded 23.6 percent after plunging a revised 36.7 percent in May. The June pace recovered to an annualized 330,000 from a revised 267,000 for May and revised 422,000 for April. While the comeback is welcome, the bad news is that May's record drop was revised down notably from the initial estimate of a 33.0 percent decline. The latest figure is down 16.7 percent on a year-ago basis.

Another factor that suppresses demand is surprise, deflation. We are now in a deflationary environment, and studies show that consumers hold back from purchases if they believe prices can fall further—which creates a self-fulfilling prophecy. So rising prices also will signal increasing demand.

For instance, the just released second quarter Gross Domestic Product report showed falling prices. Though economy-wide inflation accelerated in the second quarter as the GDP price index rose an annualized 1.8 percent, following a 1.0 percent in the first quarter.

The acceleration in prices was due to the impact from higher imports—which signals greater domestic demand. But the price index for gross domestic purchases, which measures prices paid by U.S. residents, increased a bare 0.1 percent annualized in the second quarter, following a 2.1 percent boost in the first quarter. The core rate excluding food and energy prices increased just 0.9 percent in the second quarter, compared with a rise of 1.6 percent in the previous quarter.

So despite all of the doomsayers, the recovery continued in the second quarter but at a moderate pace. Yes, growth is still below par but not into a double dip, thanks mainly to the TARP and ARRA programs’ stimulus spending. Second quarter GDP came in at an annualized 2.4 percent growth, following a revised first quarter gain of 3.7 percent.

The latest quarter was led by a rebound in residential investment, a jump in investment in equipment & software, and by inventories. Personal Consumption Expenditures also posted a moderate gain along with government purchases.

In fact, the best measure of pent-up demand, is what is called the “output gap”.  The San Francisco Federal Reserve puts out that calculation. It was minus 6.1 percent in Q1 2009, but would have been as high as 19 percent without the TARP and ARRA stimulus spending, says the Center for Budget and Policy Priorities (CBPP), a non-partisan think tank.

The output gap measures how far the economy is from its full employment or "potential" level that depends on supply-side factors of the economy: the supply of workers and their productivity. During a boom, economic activity may for a time rise above this potential level and the output gap is positive. During a recession, the economy drops below its potential level and the output gap is negative. In theory, the output gap can play a central role in monetary policy deliberations and strategy.

In fact, one of the goals of the Federal Reserve is to maintain full employment, which corresponds to an output gap of zero. And it is the employment rate that best determines output, so we know that the Fed isn’t going to begin to raise interest rates, until the unemployment rate declines substantially, which means that pent-up demand will begin to kick in.

Was Bernanke being too optimistic? We don’t think so, nor does the stock market, which continues to rally.

Harlan Green © 2010