by Calculated Risk on 1/25/2006 10:46:00 AM

The Mortgage Bankers Association (MBA) reports: Mortgage Application Volume Up In Latest Survey

Click on graph for larger image.

The Market Composite Index — a measure of mortgage loan application volume was 660.5 -- an increase of 7.7 percent on a seasonally adjusted basis from 613.3 one week earlier. On an unadjusted basis, the Index decreased 0.2 percent compared with the previous week and was down 0.4 percent compared with the same week one year earlier.

The seasonally-adjusted Purchase Index increased by 6.7 percent to 473.7 from 443.9 the previous week whereas the Refinance Index increased by 7.8 percent to 1773.9 from 1645.2 one week earlier.

Rates on fixed mortgages decreased slightly again, but ARM rates increased:

The average contract interest rate for 30-year fixed-rate mortgages decreased to 6.04 percent from 6.07 percent on week earlier ...

The average contract interest rate for one-year ARMs increased to 5.44 percent from 5.39 percent one week earlier ...

The MBA survey indicates RE activity is still at a fairly high level and rebounding in January.

by Calculated Risk on 1/25/2006 10:27:00 AM

The AP reports: Existing Home Sales Set Record but Cooling

Sales of existing homes set a record for a fifth straight year in 2005 even though the year ended on a weaker note with three straight monthly declines, sending a strong signal that the nation's housing boom is beginning to cool.

The National Association of Realtors reported that sales of previously owned homes and condominiums dropped by 5.7 percent in December compared to the sales pace in November. It marked the third consecutive monthly decline, something that has not occurred in more than three years.

From the NAR:

Existing home sales fell to a 6.6 million annual rate in December, 3% lower than December 2004.

Inventories fell to 2.796 million units, from 2.924 units in November, as sellers took their houses off the market for the holidays. However, inventories are up 26.3% compared to December 2004. This represents of 5.1 months of supply at the current sales rate.

The average and median prices fell to levels not seen since May 2005. Average prices were up 7.4% for the year, and median prices up 10.5%.

by Calculated Risk on 1/24/2006 08:54:00 PM

Federal Reserve economist John Rogers (Chief, Trade and Financial Studies Section) and University of Wisconsin Professor Charles Engel, in a new paper "The U.S. Current Account Deficit and the Expected Share of World Output", Journal of Monetary Economics suggest the US Current Account Deficit may be near optimal levels.

From their conclusions:

We have asked whether the U.S. current account deficit could be consistent with expectations that the U.S. share of world GDP will increase. Under assumptions about the growth in the net GDP share that are not wildly implausible, the level of the deficit can be consistent with optimal saving behavior. But, in making this assessment, we emphasize that there are many difficult issues to deal with, and the conclusion is sensitive to how one handles these questions.

First, our findings are sensitive to how we treat two problems: the high saving rate in East Asian emerging economies, and the "exorbitant privilege" (the term used by Gourinchas and Rey (2005)) that allows the U.S. to receive a much higher return on its foreign investments than foreigners earn on their U.S. investments.

On the first point, most forecasters predict that the emerging market's share of world GDP will be increasing over time. Our empirical work does not include these countries, and if it did, the forecast path of the U.S. share of world GDP would not be as rosy. But, according to themodel, these countries ought to be borrowers in international capital markets. They are not -- they are large net lenders. It is puzzling that they are net lenders. Bernanke (2004) refers to this as a "savings glut", and hypothesizes that these countries are in essence building up a nest egg in order to protect them against a possible future international financial crisis such as the one that beset East Asia in 1997-1998.

We are not sure how to handle this in our model. It may be that these countries will continue to be high savers, in which case their saving will hold down world interest rates and the U.S. deficits will be more justifiable. On the other hand, their saving rate may fall and real interest rates may rise, which works toward the U.S. optimally having a smaller deficit.

We make the "heroic" assumption in our work that these countries are not contributing to net world saving at all. On the one hand, this is a conservative assumption (if one is trying to explain the large U.S. deficits), because the countries are in fact large net savers. On the other hand, if their net saving is reversed, the assumption is too optimistic.

It does seem like markets favor the position that these countries will maintain their positions as large savers, because long term real interest rates are very low. However, much of the recent scholarly and policy-oriented research on the U.S. current account deficit has taken the position that the markets may not be correctly foreseeing events.

Finally, it is possible that the saving rate is high in East Asian countries because of demographic factors. It has been noted that because of the one-child policy, the ratio of old to young is increasing rapidly in China. There are other countries for which demographic factors may be very important as well, and this deserves further study.

We take a similar neutral position on the exorbitant privilege. One possibility is that the U.S. will continue to receive higher returns on its foreign investments than it pays out on its foreign borrowing. On the other hand, that privilege may disappear, and worse, it may disappear not only for future borrowing but also for our outstanding debt when it is refinanced. Our work takes a somewhat neutral position by assuming future borrowing and lending takes place at the same rate of return, but that there is no additional burden to be encountered from refinancing existing debt at less favorable rates of return.

There really are a variety of scenarios that could play out. As Gourinchas and Rey (2005) demonstrate, it is not only that the return on U.S. assets within each asset class is lower than on foreign assets (implying the market views U.S. assets as less risky), but also that the mix of U.S. investments abroad favors riskier classes of assets. It is possible that the U.S. net return will fall in the future both because the risk premium on U.S. assets rises (as in Edwards (2005) or Blanchard, Giavazzi and Sa (2004)), and because foreigners shift toward investing in more risky U.S. assets. But, again, it is notable that markets do not reflect any increasing riskiness of U.S. assets.

With these major caveats in mind, we find that the size of the U.S. current account deficit may be justifiable if markets expect further growth in the U.S. share of advanced-country GDP. The growth that is needed does not appear to be implausible.
But, what the model cannot explain is why the U.S. current account deficit continues to grow. If households expect the U.S. share of world GDP to grow, they should frontload consumption. The deficits should appear immediately, not gradually.

We have allowed in our Markov-switching model for the possibility that there was a shift in regime that U.S. households only gradually learned about. But that turned out not to be able to explain the rising U.S. current account deficits. However, our simulations and estimation assumed that households understood that if a regime shift took place, the U.S. share of world GDP in the long term would be much higher than it was in the early 1980s. In practice, it may be that markets only gradually learned the U.S. long-term share. Examination of the model when there is only gradual learning about the parameters of the model will be left for future work. It is possible that because U.S. households only gradually came to the realization that their share of advanced country GDP was going to be much higher in the long run, they only gradually increased their borrowing on world markets.

This possibility is supported by our examination of the consensus long-term forecasts of U.S. GDP relative to G-7 GDP since 1993. These forecasts have consistently underestimated U.S. GDP growth relative to other countries, by wide margins. The current forecasts for the future, however, show that the markets expect a large increase in the U.S. share of GDP – almost precisely the amount that we calculate would make the current level of the deficit optimal.

There are at least two other possible explanations to explain this gradual emergence of the current account deficit. One possibility is that it takes time for consumption to adjust. This could be modeled either with adjustment costs, or, as is popular in many calibrated macro models, with habit persistence in consumption.
Another possibility is that there has been a steady relaxation of credit constraints for many U.S. households, as well as increased access to U.S. capital markets for foreign lenders. The relaxation of credit constraints was one of the possibilities that Parker (1999) explored in his study of the decline in U.S. saving. He found that it could explain at most 30% of the increase in consumption from 1959 to 1998.

The starting point of Parker's back-of-the-envelope calculation is the observation that the consumption boom is the equivalent of three-quarters of one year's GDP in present value terms. The rise in debt, as measured by the difference in ratios of household total assets to income and net worth to income, was about 20 percent over the period. Therefore, debt can explain at most .20/.75 < 30 percent of the increase in consumption. Since the time Parker wrote his paper, debt has continued to rise, by another 25% through 2005Q2 when the ratio of total assets to income exceeded the ratio of net worth to income by 1.24.

Of course, the other obvious candidate for the increasing U.S. current account deficit is through the effect of U.S government budget deficits. It is useful to note that what we are really talking about is the effects of tax cuts. In the first place, government spending as a share of GDP has not changed dramatically, so could not account for the large current account deficit. Moreover, our analysis allows for the effects of increases in government spending. An increase in current spending above the long-run spending levels would lower the U.S. share of GDP net of government spending and investment relative to future shares, thus inducing a greater consumption to net GDP ratio.

But our model assumes that the timing of taxes does not matter for household consumption -- that Ricardian equivalence holds. Obviously that might not be correct. Recent empirical studies do not show much support for Ricardian equivalence, though the point is debated.8 We note that to the extent that credit constraints have been relaxed in recent years, Ricardian equivalence becomes a more credible possibility. It may be that in more recent years, lower taxes do not boost consumption as much, and instead allow households to pay off some of their credit card debt or prepay some of their mortgage. It may be interesting to pursue empirically the hypothesis that the effects on national saving of tax varies change with the degree of credit constraints in the economy.

Another argument that needs to be explored is the distributional effects of the recent tax cuts. It has been argued that the tax cuts were less stimulative than previous cuts because they accrued mostly to wealthy individuals, who simply saved the additional after-tax income. (That is, the rich act more like Ricardian consumers.) But if that is the case, then it is more difficult to make the case that the tax cuts are responsible for the decline in U.S. national saving.

Finally, we cannot reach firm conclusions about the future path of U.S. real exchange rates. We have calibrated a model that is essentially identical to the one examined by Obstfeld and Rogoff (2004), but one in which the consumption path is determined endogenously as a function of current and expected discounted real income in each country. We found that under one set of baseline assumptions, there should not be much change in the equilibrium real exchange rate as the U.S. current account adjusts. Our model assumes the U.S. will experience higher growth in productivity in both traded and non-traded sectors, and that there is factor mobility between the traded and non-traded sector. On the one hand, if traded/non-traded productivity growth in the U.S. is slightly higher than in the rest of the world, the price of non-traded goods will rise in the U.S. from the Balassa-Samuelson effect. On the other hand, the U.S. terms of trade should fall as the supply of its exports increases. If there is home bias in consumption of tradables, that would work toward causing a U.S. real depreciation. In our baseline calibration, these two effects approximately cancel.

But as we have noted, the conclusions about the real exchange rate depend on assumptions about parameters of the model. Particularly, if the elasticity of substitution between imports and exports in consumption is much lower than our baseline simulation assumed, the U.S. could experience a substantial real depreciation over the next 25 years.

The basic message of our paper is that there are many aspects of the current account adjustment that are just not possible to predict. Under some scenarios that we do not regard as entirely unreasonable, we find that the U.S. current account deficit can be explained as the equilibrium outcome of optimal consumption decisions. But some of our modeling simplifications and assumptions might be wrong in important ways, and so it may turn out, as many have been warning, that the deficits have put the U.S. on the path to ruin.

by Calculated Risk on 1/24/2006 06:23:00 PM

Dr. Brad Setser excerpts from Robert Rubin's Wall Street Journal OpEd and adds some interesting commentary. Setser writes:

Thomas Palley is right: "Foreign flight" (a shock to the United States ability to borrow savings from abroad) is very different from "Consumer burnout" (a slowdown in US demand growth). In both the foreign flight and the consumer burnout scenarios, the US economy slows and the dollar falls. But in the foreign flight scenario, as Palley notes, the fall in the dollar and rise in US (market) interest rates triggers the US slowdown, while in the consumer burnout scenario, the US slump triggers dollar weakness. Foreign flight would combine dollar weakness with higher US (market) interest rates, consumer burnout combines dollar weakness with lower interest rates.

A housing market slowdown, and lower mortgage equity withdrawal, might lead to "consumer burnout". This is a potential problem right now for the US economy. But the addition of "foreign flight" might lead to a vicious cycle on the downside.

Click on diagram for larger image.

This diagram is from an earlier post. The diagram depicts a virtuous cycle that might have been occurring over the last few years. Lower interest rates leads to higher housing prices and this leads to more equity withdrawal, higher consumption and more imports. Flush with cash, foreign CBs invest in dollar denominated bonds leading to lower interest rates ... and the cycle repeats.


Unfortunately, as the second diagram depicts, this has the potential to become a vicious cycle as housing slows. As Dr. Setser concludes:

But as US rates start to fall, foreign investors lose interest in lending even more to the US. Rather than adding $1 trillion or so to their portfolio of dollar denominated bonds at 4.5%, they want to add only say $600 billion or so ... Reduced foreign demand for US dollar assets ends up pushing US interest rates up.

At least those interest rates that are set in the market. The Fed's response to consumer burnout could trigger foreign flight.

That is a bad scenario. It implies that the US economy wouldn't benefit from some of the stabilizers that normally buffer the US from really bad (economic) outcomes.

Of course, this was my top economic prediction for 2006:

I think long rates will start to rise when the Fed starts cutting the Fed Funds rate.

This will be Bernanke's "conundrum"! As the economy slows, this will reduce the trade deficit and also lower the amount of foreign dollars willing to invest in the US - the start of a possible vicious cycle.

Also, see Dr. Kash's post today: Will the Fed Overshoot?

by Calculated Risk on 1/23/2006 08:48:00 PM

From a Financial Times article: Prospect of housing downturn casts pall over US economy

The ratio between average income and the costs associated with buying a home has risen to record levels. "Strong price growth momentum has resulted in very high prices relative to incomes across the country," says Ian Morris, chief US economist at HSBC.
...
Mr Morris says a "bubble zone" has been created where house prices are overvalued by 35-40 per cent, equivalent to $6,000bn. Although this bubble could take time to deflate, Mr Morris warns that "the consequences of a punctured housing bubble could be traumatic". Even a soft landing of zero house price growth, he says, will dry up the mortgage equity withdrawal that has fuelled consumer purchasing. Consumer spending makes up two-thirds of the US economy.

So could a bursting of the housing bubble pull the US economy into recession?

Mr Morris says yes. "If this adjustment can be managed over many years, the economy can avoid recession. If the process is squeezed into a shorter time-frame instead, then recession is probable."

The article offers other views too. The data later this week might be interesting.

by Calculated Risk on 1/23/2006 05:16:00 PM

On Angry Bear, I reported the newest Bush Approval (actually disapproval) ratings.

Now Gallup reports: Many States Shift Democratic During 2005


Click on map for larger image.

Note: Gallup doesn't normally interview in Hawaii and Alaska. I added both states.

This shift is probably due to the dissatisfaction with Bush's policies. It will be interesting to see if this translates to Democrat victories later this year.

by Calculated Risk on 1/22/2006 10:24:00 PM

In Monday's WaPo: As U.S. Economy Has Thrived, So Has Debt

"The jury is out on his legacy in large part because of the debt" and the trade deficit, said Stephen S. Roach, chief economist at Morgan Stanley. "You will not be able to truly judge his accomplishments until we see how this plays out in the post-Greenspan era."

The article offers these examples:

· U.S. household debt hit a record $11.4 trillion in last year's third quarter, which ended Sept. 30, after shooting up at the fastest rate since 1985, according to Fed data.

· U.S. households spent a record 13.75 percent of their after-tax, or disposable, income on servicing their debts in the third quarter, the Fed reported.

· The trade deficit for last year is estimated to have swollen to another record high, above $700 billion, increasing America's indebtedness to foreigners.

The debt binge has definitely contributed significantly to the current recovery. The big question is what happens next?

by Calculated Risk on 1/22/2006 06:00:00 PM

The Ports of Long Beach and Los Angeles reported a seasonal decrease in import traffic for December.

Import traffic at the Port of Long Beach decreased 12.7% compared to November and was 1.2% less than December 2004. A total of 266 thousand loaded cargo containers came into the Port of Long Beach, compared to 305 thousand in November. The record is 313 thousand set in August 2005.

The Port of Los Angeles import traffic decreased 1.2% in December compared to November, but imports were up 16% from December 2004. Imports were 321 thousand containers. The record for the Port of Los Angeles was set in October with 368.5 thousand import containers.

For Long Beach, outbound traffic was down 3% to 104 thousand containers. At Los Angeles, outbound traffic was steady at 98 thousand containers.

The quantity of containers says nothing about the content value, but provides a rough guide on imports from China and the rest of Asia. Given these numbers, I expect imports from Asia to be lower in December than in November.

by Calculated Risk on 1/22/2006 01:03:00 AM

First, it is fairly clear, as pgl notes, that Iran is not currently an imminent threat to the US. But what about the economic issues with the "Iranian Oil Bourse"?

Dr. Hamilton has a nice post addressing that issue: Strange ideas about the Iranian oil bourse

I agree with Dr. Hamilton, but I'm afraid the actual economic impact (or lack of economic impact) doesn't really matter. What matters is what Bush / Cheney think. Although the Bourse is inconsequential, an attack on Iran could have significant economic implications.

In my economic predictions for 2006, I included this caveat:

So, without trying to predict natural disasters, a pandemic or human stupidity (terrorism, bombing Iran, etc.), ...

And for some reason I'm reminded of the fictional character Forrest Gump's quip: "Stupid is as stupid does." Lets hope the US is not stupid this time, otherwise $68/barrel WTI oil might look cheap, and my 2006 economic predictions wildly wrong.

by Calculated Risk on 1/20/2006 11:42:00 PM

Morgan Stanley's Chief Economist Stephen Roach writes: The Irony of Complacency

So far, so good, for an unbalanced world -- the sky has yet to fall.

... suffice it to say, were it not for another year of solid support from US consumer demand -- our latest estimates put real consumption growth at an impressive 3.5% in 2005 -- the rest of a largely externally dependent world would have been in big trouble.

What did it take for the American consumer to deliver yet again? ... With America’s internal income-generating capacity continuing to lag, US consumers once again tapped the home equity till to draw support from the Asset Economy. According to Federal Reserve estimates, equity extraction by US households topped $600 billion in 2005 -- more than enough to compensate for the shortfall of earned labor income. Comforted by this asset-based injection of purchasing power, consumers had little compunction in stretching traditional income-based constraints to the max. The personal saving rate fell deeper into negative territory that at any point since 1933, and outstanding household sector indebtedness -- as well as debt service burdens -- hit new record highs.

So much for what happened in 2005. The big question for the outlook -- and quite possibly the most important macro issue for world financial markets in 2006 -- is whether the American consumer can keep on delivering. My answer is an unequivocal “no.”

Roach is always interesting reading.