The employment situation in October improved dramatically with 337,000 jobs added to payrolls -- well above expectations and the biggest gain since March. Construction accounted for more than one-in-five new jobs, as the strength of new residential starts pushed up employment by 71,000. Construction continues to be the star performer of the past couple of years, with employment gains in 20 of the past 22 months; October's gain was the biggest since March 2000. All major sectors added workers save for manufacturing, which lost 5,000 jobs. An improving labor market encouraged some people to re-enter the labor market, causing the labor force to grow by more than the hefty job gain. As a result the unemployment rate drifted up to 5.5 percent, but we expect it to retrace this over the balance of the fourth quarter.

Even though the economy has added 2.1 million payroll jobs over the past 12 months, there still remains slack in the labor market with little upward pressure on wages. The government's Employment Cost Index -- a comprehensive measure that includes wages, benefits, and employer tax payments -- rose only 2.4 percent over the past year, similar to the Consumer Price Index's rise of 2.5 percent over the 12 months ending September. Thus, after accounting for general price inflation, real employment costs are unchanged over the past year.

The housing and mortgage markets continue to play a critical role in supporting the economic recovery. Single-family starts will set a new annual record this year (helping to propel construction employment), and remodeling expenditures continue to run high with a 14 percent gain in the most recent data (first quarter 2003 to first quarter 2004) to a record $144 million annual rate of spending. A flexible housing finance system supplies the funds to keep home sales and home improvements running at record levels. We expect home sales to set a new volume record of 7.9 million new and existing house sales (or, over 9 million sales, inclusive of condominiums). Home equity extraction through cash-out refinance is projected to total about $120 billion in 2004, supplying the funds to support home improvements, debt consolidation, and overall consumer spending. Indeed, personal consumption spending accelerated to a 4.6 percent annualized growth rate during the third quarter, supporting the pickup in GDP growth to 3.7 percent, annualized.

The October jobs report should eliminate any remaining doubt about the Federal Reserve's next policy decision: It will raise the federal funds target another one-quarter percentage point to 2 percent on November 10. Another strong jobs report next month could lead the Federal Reserve to one more increase before the year is out.

• Real GDP growth. The Bureau of Economic Analysis reported the advance estimate of third quarter GDP growth at 3.7 percent, lower than our expected growth rate of 4.0 percent (annualized). Due to the continuation of high energy costs we have set our fourth quarter forecast for GDP growth at 3.5 percent, with higher growth expected in 2005.

• Consumer price inflation. After a second quarter, energy-cost-induced spike in the consumer price index (CPI), CPI inflation should return to a more moderate pace, averaging at about a 2 percent inflation rate in 2005, unchanged from our previous outlook. Oil prices remain the wild card and biggest downside risk to our forecast. The current price of a barrel of sweet crude oil has finally come down under $50 a barrel, however the home heating season is upon us and families will feel the pinch from high fuel costs heading into the Christmas buying season. Nonetheless, we expect oil prices to gradually drift downward in 2005, helping to keep inflation low.

• Unemployment rate. Our unemployment rate forecast is unchanged from last month. With GDP growth expected to exceed 3.5 percent, job creation should bring the unemployment rate gradually down, to close to 5 percent by the end of 2005. The October jobs report indicated a rise in the unemployment rate to 5.5 percent despite a gain of 337,000 new non-farm payroll jobs. We believe this is a temporary increase in the unemployment rate and that jobs growth should exceed 150,000 over each of the months in the fourth quarter, bringing the unemployment rate back down.

• Mortgage rates. 30-year fixed mortgage rates averaged 5.72 percent during the month of October; fixed-rate loans are only about 50 basis points above the 46-year low set in June 2003. We expect fixed-rate loans to gradually become more expensive, increasing about one-half of a percentage point between now and the end of 2005, however our average expected rate for 2005 is 10 basis points lower than our previous forecast. ARM rates should increase by more because we expect the Fed to continue to push the federal funds target higher -- we expect another quarter-point increase, to 2 percent, on November 10.

• Housing starts. Low mortgage rates continue to foster new housing demand, either through household formations or desire for second homes. Our expectation for total housing starts in 2004 is at 1.96 million units, up slightly from our October Outlook, and we increased our housing starts projection to 1.84 million dwellings for 2005.

• Home sales. Both previously owned and newly built home sales will easily set records this year, of about 6.5 million and 1.2 million units, respectively. We increased the total home sales forecast to 7.67 million for 2005 -- a 3 percent dip from the level set in 2004 attributable to slightly higher mortgage rates; this is a higher projection than last month's estimate and it ties to our lower interest rate forecast for the year.

• Home value appreciation. Home price growth will moderate over the next year, to about an 8 percent annual growth rate. Strong homes sales and an improving employment outlook coupled with higher construction costs and very little buildable land in the fastest growing areas are keeping up pressure on home prices. Although we expect this pressure to moderate a bit with higher interest rates, we do not foresee any reason for a correction.

• Mortgage activity. The Fed-induced flattening of the yield curve (primarily through raising short-term rates) will bring the ARM share of lending down slightly over the next year. Higher rates will also dampen refinancing volume, from a share of 46 percent in 2004 to about 40 percent in 2005. After a four-year refinance boom, fewer than 1-in-7 borrowers with a fixed rate mortgage today have an interest rate of 7 percent or higher -- so very few homeowners are "in the money" for a refinance based purely on prevailing mortgage rates. Based on our lower interest rate forecast and strong home sales, we pushed up our origination forecast to $2.7 trillion for 2004 and $2.5 trillion for 2005 -- all of the difference in origination volume is due to lower expected refinance activity.

Published: November 9, 2004

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