February 2006

Fourth Quarter 2006: Soft Patch Owing to Unsusal Factors

The U.S. economy hit a temporary soft patch last quarter when GDP growth slowed to a 1.1 percent annual pace from 4.1 percent in the third quarter. However, much of this deceleration owes to unusual factors, with a plunge in auto purchases cutting 2.5 percentage points off the growth rate, government spending trimming another 1 percentage point, and hurricane-related disruptions hurting domestic energy production (Chart 1). Some of these factors may have also downwardly and temporarily affected productivity, which dipped last quarter. The drop in auto purchases largely reflected the unwinding of earlier surges in sales induced by special sales incentives.

Other reports also suggest that the fourth-quarter slowing in GDP growth was temporary. After plunging in the early fall—when hurricanes devastated the Gulf Coast—consumer confidence has recovered and even surpassed its pre-Katrina readings (Chart 2). Similarly, the purchasing managers indexes for manufacturing and nonmanufacturing activity have rebounded from their hurricane-related lows, while initial claims for unemployment have fallen from their post-Katrina highs to levels well below those of last summer.

Job growth also bounced back in late 2005, with payrolls expanding by an average of nearly 250,000 in November (354,000) and December (140,000) and with jobs expanding by a healthy 193,000 in January (Chart 3). Robust job growth has occurred even though service-sector employment gains have been held down during the current economic expansion by productivity growth associated with the adoption of more self-service technologies, particularly in the retail trade sector. After dipping in December, the unemployment rate fell further in January, to 4.7 percent. Overall, employment data suggest that the job market not only has largely recovered from hurricane effects, but also is exhibiting underlying strength as firms have become confident enough to expand payrolls.

Another positive sign is the continued rise in unfilled orders for durable goods, which will likely sustain further growth in manufacturing output in coming quarters (Chart 4). Furthermore, new orders for durable goods in November and December increased faster than most market analysts had expected. Much of this reflected a very large surge in aircraft orders from foreign airlines, which bodes well for future exports. In addition, excluding aircraft, nondefense capital goods orders improved in the last two months of 2005, after stalling in the early fall.

On the other hand, housing activity may be ebbing. Housing starts fell in December to a still-high level of 1.93 million units (Chart 5, upper panel). While weather may have contributed to the drop, the less weather-sensitive and more reliable housing permits series also declined, but by half as much. These declines were not due to a downswing in the volatile multifamily segment but rather in the single-family market, where permits fell in every broad region of the United States. Because of building lags, the number of single-family units under construction continued increasing, albeit at a slower pace. If the slight downtrend in permits since the summer continues, residential construction might ebb from current high levels sometime this year.

The continued downward trend in mortgage applications for home purchases through late-January suggests that home sales may not have recovered from recent declines (Chart 5, lower panel). Other data suggest that the pace of home price appreciation may be slowing, which may reduce the extent to which households will tap housing wealth to spend on consumption, home improvements and non-mortgage debt retirement.

Most measures of core inflation have decelerated some in the last several months, but the underlying trends in core Personal Consumption Expenditures (PCE) inflation may not be as sanguine as the overall core PCE measure suggests (Chart 6). Indeed, much of deceleration in this inflation measure occurred in non-market-priced components (religious and welfare activities, nonprofit hospital care and unpaid services in finance). As a result, the market-based core inflation measure has only edged down 0.1 percentage point off its most recent high. At 1.65 percent, this inflation gauge remains in the upper end of the range over the short time period for which official data are available.

To what extent this quarter’s rebound in growth merely reflects a temporary unwinding of hurricane effects remains to be seen, but the combination of steady growth in non-aircraft capital goods orders, a sizable backlog of unfilled durable goods orders and solid growth in payroll employment suggests that the near-term economic expansion is well-entrenched. The bounce-back of private sector activity, coupled with government-funded rebuilding efforts in the Gulf Coast, will likely boost growth in the first half of 2006. The big question is how much this strength will continue afterward and whether slower home price appreciation and other factors will moderate economic growth later this year and into 2007.

—Nicole Ball, John V. Duca and Christine Rowlette