October 29, 2007
hp-652

Treasury Assistant Secretary for Economic Policy
Phillip Swagel
Statement for the Treasury Borrowing Advisory Committee of the
Securities Industry and Financial Markets Association

Washington- A variety of indicators suggest that the economy grew at a healthy pace in the third quarter, notwithstanding the housing slump, credit market disruptions, and high energy prices. While the weak housing sector looks to be a drag on GDP for the next several quarters, the housing downturn does not appear to have had serious impacts on other parts of the economy. The labor market remains broadly healthy, with low unemployment, continuing job creation, and wage gains that should support consumer spending. World output growth has boosted net exports. Core inflation appears to be contained. Looking forward, however, the ongoing drag from construction, the problems in credit markets, and higher oil prices have led private forecasters to reduce their projections for GDP growth in the fourth quarter of 2007 and into 2008.

The downturn in the housing sector has not ended as quickly as appeared to be possible at the end of 2006. The housing correction comes after an eight-year period of exceptional home price appreciation, in which strong demand for housing was fueled in part by ample liquidity. Rising homebuilding activity helped to propel GDP growth, adding an average of about half a percentage point to GDP growth rates in each quarter from 2003 to 2005. Easy credit took the form of increased use of adjustable-rate mortgages (ARMs), hybrid-ARMs with low teaser rates, interest-only features, low- or no-down payments, and even negative amortization. These practices exposed mortgage holders to greater risk than with a traditional 30-year fixed rate mortgage with a 20 percent down payment. A significant percentage of non-traditional ARMs went to subprime borrowers, as the subprime component of total lending grew from about 2 percent of mortgages in 1998 to nearly 14 percent in mid-2007.

The housing correction began in early 2006. Home prices have decelerated considerably over the past year, with some measures of nationwide home prices showing outright declines over the past four quarters. Sales of existing single-family homes are down by 30 percent from the peak in 2005, and the inventory of unsold homes has increased to levels last seen in the early 1990s. While the subprime delinquency rate today is near the level seen in 2001, there are over seven times more subprime mortgages today than there were in 2001. It appears likely that the increased number of delinquencies will translate into further increases in mortgage defaults and foreclosures. Current trends suggest there will be just over 1 million foreclosures started this year, of which two-thirds will be in the subprime market.

Declining residential building activity has subtracted substantially from GDP growth since the correction began. Annual housing starts peaked at an annual rate of almost 2.3 million units in early 2006 before falling nearly 50 percent through September of this year. Employment in residential building, including specialty trade contractors, has dropped by almost 200,000 since early 2006, offsetting about one-quarter of the jobs gained in the housing boom. Although it appeared that homebuilding activity had reached a bottom in the first half of this year, starts and permits have both fallen further since June and the elevated level of inventories of unsold homes suggest that home construction will remain weak going forward.

Despite the downdraft from housing, other sectors of the economy have been broadly healthy--indeed, this is the first housing downturn in the past three decades in which U.S. GDP growth has not turned negative. Business investment has expanded in recent months, exports are growing strongly, and continued job creation has helped support consumer spending. Data available through August suggest that real personal consumption expenditures are on track to contribute about 2 percentage points to real GDP growth in the third quarter (at an annual rate), more than consumption contributed in the second quarter, when real GDP rose by 3.8 percent at an annual rate. Solid income gains and healthy household balance sheets have helped support household spending: Real disposable income rose 4.4 percent over the twelve months ended in August, and household net worth remained high relative to income in the second quarter.

In the business sector, core capital goods shipments rose smartly in August and September, signaling a pickup in equipment and software investment toward the end of the third quarter. Orders for core durable goods remain ahead of shipments, though the volatility of the orders data means that this provides only a modest suggestion of future strength in the durable goods categories that are most closely linked to business investment.

Export growth remained solid well into the third quarter, supported in large part by strong economic growth overseas. Over the year ended in August, U.S. exports of goods and services rose 12.8 percent. Strong export growth and slower growth of imports has narrowed the trade deficit considerably in recent months. Net exports are poised to make another substantial contribution to Q3 real GDP growth after adding 1.3 percentage points to growth in the second quarter.

Job growth moderated in the third quarter and the unemployment rate ticked higher but labor markets still appear healthy overall. Nonfarm payrolls expanded by an average of 97,000 a month in the third quarter, down from the average monthly job gain of 134,000 in the first half of the year. The unemployment rate edged up to 4.6 percent in the third quarter from 4.5 percent in the previous three quarters. Real wages in September were 1.3 percent higher than a year earlier. The level of initial claims for unemployment insurance moved up somewhat in October, but remains at a level consistent with ongoing job creation.

The federal government's fiscal position continued to improve in the fiscal year that just ended. The federal budget deficit shrank by $85 billion in FY2007 to $163 billion, due to a combination of strong receipts growth and a moderate rise in spending. The FY2007 deficit was equivalent to 1.2 percent of GDP--half of the 40-year average of 2.4 percent. At the same time, the fiscal challenge of rising entitlement spending looms just over the horizon.

Headline consumer price inflation has moved higher but core inflation remains broadly contained. Headline consumer price inflation was 2.8 percent over the twelve months ended in September, up from a 2.1 percent pace over the year-earlier period. Energy prices increased 5.4 percent over the latest twelve months, although prices have been volatile in this period, and crude oil prices have surged in the most recent few weeks. Food prices accelerated notably over the past year; September's twelve-month change of 4.4 percent was up from 2.6 percent a year ago. Excluding food and energy, consumer prices advanced 2.1 percent over the last 12 months, down from 2.9 percent in the previous 12 months.

The sharp run-up in oil prices since mid-August has prompted forecasters to lower their projections for near-term growth. The one-month futures price of West Texas Intermediate crude oil broke through the $90 a barrel mark late last week and is nearing the inflation-adjusted peak recorded in 1980. Production in the U.S. economy is less energy-intensive than was the case thirty years ago, so that the current high level of oil prices is not expected to exact the same heavy toll on the economy as in the 1970s and 1980s. Even so, high energy prices remain a challenge for consumer and business spending, while tight inventories and limited global production capacity mean that the possibility of sharply higher oil prices from a supply disruption is a key downside risk for the economy.

In sum, the U.S. economy looks set to grow at a moderate pace, even while the downdraft from the homebuilding sector and recent credit market disruptions exact a penalty on growth.