Revisiting the Sacrifice Ratio
The Federal Reserve Bank of Kansas City held its annual economic symposium in Jackson Hole last month. During this annual meeting, the world’s central bankers traditionally share their projections of economic growth and discuss prospects for inflation and employment growth. Many attendees, including Fed Chairman Bernancke, have often discussed the concept of an economy’s "sacrifice ratio."

Although the ratio is calculated using complicated econometric forecasting, simply put, it measures the relationship between: (1) the cost of lost economic production that is caused by rising interest rates versus (2) the change in the rate of inflation that is caused by dropping interest rates. That’s the Fed’s classic “Catch-22” mandate of maintaining wage and price stability.

Of late, the Fed’s calculation of this ratio has been in excess of “4,” versus the “2 – 3” range that was characteristic of the 1980’s. Translated, at this level, there would be four units of lost output for each unit of beneficial change in inflation. A rising sacrifice ratio makes it tougher on the Fed because it is thought that, in this scenario, the impact of rising rates on unemployment and lost output grows in severity. A rising sacrifice ratio also connotes greater danger in terms of making a policy error, which in turn, could explain why the Fed has embarked on its approach of gradual rate increases over the past few years.

No Place Like Home?
It’s becoming more evident (at least in terms of investable assets) that home might not be the place to be. The Office of Federal Housing Enterprise Oversight (OFHEO) recorded a 1.17% gain in national home prices for the second quarter. That’s appreciably less of an increase than the respective price gains of 2.20% and 3.08% that we saw in the first quarter of this year and the fourth quarter of 2005. The agency also cited that more than 25% of the U.S.’s 275 metropolitan areas had sustained quarter-to-quarter price declines.

In a report issued last week by the National Association of Realtors (NAR), the industry trade group expressed the probability that housing prices could “dip temporarily below year-ago levels as the market works through a build up in housing inventory.” The NAR also reduced its sales forecast for existing homes to 6.54 million units—a drop of 7.6% from 2005—and its forecast for housing starts to 1.87 million units—a drop of 9.6% from 2005.

The importance of this dampened forecast is underscored by a couple of observations found in Harvard University’s Joint Center for Housing Studies’ annual report on the nation’s housing market:

• During 2005, cash-out re-financings totaled $243 billion, a year-over-year increase of 66%.
• In broad terms, the housing sector, including home building, remodeling, rents, utilities, and furnishings represented a record 23% of the 2005 U.S. $12.5 trillion economy.
• Historically, housing bubbles tend to deflate slowly, and nominally declining prices are preceded by stagnant price appreciation for one-to-two years. Few areas have ever sustained price declines of more than 10%. When they do, it’s typically confined to specific regions that have incurred a combination of job losses, overbuilding, and population outflow.

The housing market is undoubtedly a consideration in the Fed’s deliberations. The latest “Beige Book” reported that the housing and residential construction sectors “weakened throughout the nation.”

A Good Time for a Commercial?
In that same “Beige Book” report, the Fed stated that commercial real estate and construction have actually strengthened throughout the nation. Indeed, according to the Mortgage Bankers Association, during the second quarter, commercial loan originations increased by 23%, compared with the first quarter. Increases were particularly significant in the cases of hotel, industrial, and health care properties.

While coincident indicators remain positive on the commercial real estate front, there are concerns in some circles about a pause in the capital spending cycle. Of particular concern was the revised second quarter GDP report, which showed commercial investment in new equipment and software as having declined for the first time in over three years. Also, the August Federal Reserve Bank of Philadelphia’s survey of manufacturers showed that only 21% of respondents intend to increase capital spending over the next six months.

The Labor Market: Slipping Productivity, Higher Cost
Labor productivity for the second quarter slowed to an annualized rate of 1.6% on the heels of a 4.9% first quarter gain. Along with the personal consumption expenditures price index (last reading of 2.4% (well above the 2.0% comfort zone threshold), in our view, labor productivity ranks among the most important gauges of inflation in the eyes of the Fed.

With higher wage costs (up 9.0% and 4.9% during the first and second quarters, respectively), continuing to move inversely with GDP growth during the first and second quarters, we have now seen the largest back-to-back rate of increase in labor cost increases in over six years.

With the inflation indicators still blinking “yellow,” what’s the point spread on another rate hike? For that, we turn to the implied forward yield curve that is currently calling for roughly 15% odds of a rate hike within the next three months, followed by a projection of overnight rates to be in the vicinity of 5.00% one year from now. The markets still appear to view the Fed as becoming somewhat tolerant of inflation indicators in the coming months, as they continue to assess the economic impact of the slowing housing sector and higher cumulative interest rates. Tolerance levels are starting to vary among individual Fed members. We saw our first dissenting opinion emanating from the records of the August FOMC meeting, with Richard Lacker, President of the Federal Reserve Bank of Richmond, voting for further rate hikes.

Will Labor Conditions Stay Tight?
In spite of well publicized lay-offs at Intel, Ford, and other prominent employers, lay-off notices are actually down by 7.5% from one year ago, according to the placement firm of Challenger, Gray and Christmas, Inc. Payroll numbers, a 128,000 monthly increase at last count, don’t yet appear to show any possible negative side-effects from a slower housing sector. Fed Chairman Bernancke is on record as saying that a monthly payroll increase of 130,000 is about the level that is necessary to prevent the unemployment rate at current levels.

Still, confidence seems to be waning. In its August 22 monthly survey of consumer confidence, the Conference Board reported that the percentage of respondents that expected their incomes to increase declined to 17.7% from 18.4%. Moreover, the percentage of respondents that viewed jobs as difficult to find increased over the month, from 19.6% to 21.1%.

Was the Housing Boom an Historical Aberration?
This month, the Federal Reserve Bank of Chicago (Jonas D. Fisher and Saad Quayum) issued an economic perspectives piece entitled, “The Great Turn-of-the-Century Housing Boom.” The study aims to account for the reasons why residential investment spending now accounts for over 6% of nominal GDP, which is far higher than its historical average. Some interesting findings: On a relative basis, monetary policy has been an insignificant contributor to increased spending on housing. At the margin, increased residential spending has been led by what are termed as “technology-driven developments in the mortgage market, such as sub-prime lending… and mortgages that reduce or even eliminate entirely the need for a down payment.” As such, the authors see the past several years of increased residential spending as being a temporary transition that represents a shift from would-be-renters to homeowners. The prognosis: “The current housing boom may be a temporary transition toward an era with higher homeownership rates in which spending is temporarily higher than historical norms, but will eventually return to such norms.”

Quite possibly, there are reasons outside of speculative fervor that have accounted for the unprecedented housing boom.

John Biestman is director of business development at the Federal Home Loan Bank of Seattle.

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