Fed Signals Possible End of Tightening Cycle

NAHB Chief Economist Robert Dietz wrote the following in the most recent Eye on the Economy newsletter.

The Federal Reserve’s monetary policy committee raised the federal funds target rate by 25 basis points at the conclusion of its May meeting. Although the communication from the Fed did not explicitly indicate that it is done tightening, language used in its statement signals the Fed is moving toward a more data-dependent posture, albeit one that retains a hawkish bias.

Caution would suggest the Fed pause and evaluate conditions in the coming months. Keep in mind that approximately 40% of overall inflation is generated from shelter inflation, which can only be tamed by increasing the supply of more affordable, attainable housing.

The pivot in posture by the Fed is the right call given the recent banking system weakness. Although there is no systemic threat to the financial system, the Fed’s rapid increase of short-term rates has produced hundreds of millions of unrealized losses for banks, which has led to three high-profile failures. To be clear, this is a far cry from the hundreds of bank failures during the Great Recession; yet it is a reminder that the macroeconomy has been weakened by the Fed’s actions over the last 15 months. Combined with concerns over the fiscal debt ceiling, the availability of capital for economic activity has certainly tightened, which in turn will produce additional macroeconomic slowing.

Despite these monetary headwinds, the economy continues to surprise to the upside. For the first quarter, GDP growth managed a 1.1% annualized growth rate, despite forecasts from last year (including NAHB’s) that the quarter would show a contraction. Nonetheless, contraction continues for individual sectors, including housing and real estate. The housing share of GDP declined to 15.8%, with the home building component falling back to 3.9% of the overall economy.

Indeed, lower mortgage rates and limited existing inventory (only a 2.6-month supply) helped to push new home sales up in March. The U.S. Department of Housing and Urban Development and the U.S. Census Bureau estimated sales of newly built, single-family homes in March at a 683,000 seasonally adjusted annual pace, which is a 9.6% increase over a downwardly revised reading of 623,000 in February. This pace is 3.4% below the March 2022 estimate of 707,000.

The possible end of the tightening cycle means that mortgage rates will move lower in the months ahead, sparking additional demand for housing, particularly for new construction given the lack of resale homes on the market (made worse by the mortgage rate lock-in effect, which will prevent some home owners from placing their homes on the market). This in turn will lead to a rebound for home building and help macroeconomic conditions as the economy moves into 2024.

Provided the inflation data cooperates (and it should, with a slowdown for rents expected amid growing multifamily completions), this sets up a short period of mild macro weakness for much of 2023 and gives way to improving conditions in 2024.

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