At the halfway point of 2004, the U.S. economy appears to be doing well. Employment growth is strengthening. Output is growing, and inflation appears to be quite tame. The housing market, however, is in the midst of a minor slowdown.

The preliminary report released by the Department of Commerce shows that real gross domestic product (GDP) grew by 3.9 percent. This is the third quarter of above-trend growth that has led to an improvement in the labor market.

The labor market improvement continued into the second quarter, as the employment reports for April and May showed impressive gains. June's increase was a bit smaller than those of the previous two months. The net increase in employment during the past six months has been 1.266 million. Job growth has actually been positive for the last nine months, but not until 2004 have we seen substantial increases.

Looking beyond the total, we see that much of the weakness in employment growth during the past three years can be attributed to the manufacturing sector. As a group, the non-manufacturing industries have been growing for most of that period. The losses in manufacturing have been substantial, and from 2000 until September of 2003, they more than offset the gains in the non-manufacturing sector, resulting in a net decline in employment.

Figure 1. Manufacturing’s share of total employment.

The effects of the weakness in manufacturing have varied considerably around the country. Figure 1 shows what share of each state's jobs were in the manufacturing sector in 2003. The figure clearly shows the concentration of manufacturing jobs in the Midwest and South.

Figure 2. Single-family housing starts, percent change 2003 to 2004.

The considerable variation in job creation across the states results in clear differences in performance of housing markets across the nation. Figure 2 shows the percent change in single-family housing starts expected for each state from 2003 to 2004. There is a strong correspondence between the states as shown in Figures 1 and 2.

Generally, Rocky Mountain states, where the concentration of manufacturing jobs is relatively small, perform better. The same can be said for Florida, Maryland, and Virginia, although some of the strength in Maryland and Virginia is due to the continued buildup of federal employment in the area of Washington, D.C., attributable to concerns about homeland security.

Besides local job growth, there are several "macro" factors that will contribute to the state-by-state performances shown in Figure 2. While job growth has returned, it is not expected to be spectacular during the next two years. Instead, a steady increase in jobs that averages about 1.8 percent per year is expected in 2004 and 2005. This is enough to bring the unemployment rate down, but the decline is expected to be modest.

The U.S. unemployment rate should drop from 5.5 percent in the second quarter of 2004 to 5.1 percent by the end of 2005. Since job growth and housing demand are so tightly tied, this will only provide modest stimulus to housing demand.

Mortgage Rates Going Up

Offsetting the positive effects of a better economy and stronger job growth during the next two years will be a changed Federal Reserve policy that will lead to higher mortgage rates. Recent consumer price index and producer price index reports have signaled a pickup in inflation, albeit modest.

The Federal Reserve has indicated recently its concern about new inflationary pressures. In particular, it has indicated a need to respond to these pressures early. The long lags in the effects of monetary policy require an early diagnosis and response.

It has become increasingly clear that the Federal Reserve's focus has shifted from concern about getting the economy moving to concern about higher rates of inflation. This will lead it to raise interest rates during the next two years.

Indeed, the Federal Open Market Committee (FOMC) increased the federal funds rate by 25 basis points at its June 30 meeting, signaling a major change in policy. No further action by the Federal Reserve is expected until after the election, but then the actions are likely to be greater.

By the end of the year, the federal funds rate is expected to be 2 percent compared to its level of 1 percent during the first half of 2004. This will take the fixed mortgage rate as measured by the Federal Home Loan Mortgage Corporation (FHLMC) weekly survey to 6.4 percent by the end of the year. While recent weekly readings are near this level, the market appears to be anticipating stronger Federal Reserve action this summer than is likely, so that these rates should fall off slightly during the next few weeks, after which they will begin a steady climb upward.

In 2005, the Federal Reserve will continue to move the federal funds rate toward a "neutral" value - that is, one consistent with stable long-term growth of the economy. That value is probably about 4 percent, with overall price inflation of about 2 percent. This will take the average mortgage rate on fixed-rate mortgages to 7.6 percent by the end of 2005.

The housing market is expected to weaken further during the second half of 2004. After peaking at just over 2 million during the fourth quarter of 2003, total housing starts are expected to be 1.7 million during the fourth quarter of 2004.

Both single-family and multifamily housing starts will see declines during the year. From the fourth quarter of 2003 to the fourth quarter of 2004, each segment of the housing market is expected to see a 16 percent decline.

Figure 3. Single-family housing starts, percent change 2004 to 2005.

During 2005, the market will continue to contract, but at a slower rate. From the fourth quarter of 2004 to the fourth quarter of 2005, single-family housing starts will fall by 2 percent; at the same time multifamily housing starts will decline by 6 percent.

Figure 3 shows that almost all areas of the country will see a decline in single-family housing starts in 2005, as rising interest rates adversely affect affordability.

Stanley F. Duobinis, Ph.D., is president of Crystal Ball Economics Inc., Millersville, Md. He can be reached at 410-987-9623 or

Publication date: 07/19/2004