(September 25, 2006) Following a strong start to 2006, California’s economic performance has slipped while the U.S. economy has slowed as consumers have restrained their discretionary spending, according to the latest quarterly report of the California Chamber of Commerce Economic Advisory Council (EAC).
At the same time, the national housing market has slowed markedly and home equity borrowing (a key source of spending over the past few years) is tapering off. Job growth has slowed to an average monthly increase of 140,000 this year, from an average 165,000 per month in 2005. Also, after a surge in capital spending in the first quarter, there are signs that businesses are paring capital spending plans.
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Interest Rates
The Federal Open Market Committee (FOMC) has raised its Fed Funds target from 1 percent to 5.25 percent since June 2004. The FOMC did not boost rates at its August 8 meeting, but maintained a bias toward higher interest rates due to recent elevated inflation readings.
The Fed’s favored inflation measure is the core personal consumption expenditure deflator, which was up 2.4 percent year-over-year in June and above the Fed’s desired 1 to 2 percent range. Historically, above-average inflation has lingered for several months after the Fed Funds rate peaks, and the Fed risks inducing a recession if it waits for inflation to decline before it stops raising rates.
The Fed has indicated that it is taking a forward-looking view of the economy and inflation in its interest rate decisions. Nevertheless, there is a chance that the Fed will over tighten as financial markets pressure Fed Chairman Bernanke to prove his anti-inflation credentials.
California
Last year the California economy slighted outpaced the national economy, after trailing the nation by a small margin earlier in the economic expansion. But the state’s performance has slipped behind during recent months.
California’s job growth may remain subdued, mainly because the state’s recovery has been overly dependent on construction and real estate jobs in recent years. While job growth in housing-related industries is tapering off, remaining job growth is becoming more balanced across industries, with notable improvements in high technology and tourism-related sectors over the past year.
Growth is also more balanced across regions, with a notable improvement in the Bay Area economy and labor market. While venture capital spending is well below levels seen during the dot-com boom, the EAC has observed increased start-up activity in the Silicon Valley and a subsequent increased demand for technically trained workers.
While the Southern California economy is also seeing a housing-induced slowdown, it continues to benefit from its diversity, with solid performances in international trade, technology, aerospace and tourism.
Despite the recent slowdown, the EAC still believes that California’s highly diverse business structure will enable it to withstand the ongoing slowdown in the housing market. But a national recession — triggered by higher oil prices and Fed tightening — would also imply a recession in California.
The EAC identified several other developments that should offset more negative economic forces affecting the California economy in coming months. First, there has been a healthy pickup in non-residential construction and real estate, which will partly offset the slowdown in residential real estate markets. Second, despite a reported slowdown in U.S. capital spending in the second quarter, the council anticipates that capital spending will bounce back to make up for insufficient investment in recent years. This will benefit California’s high technology companies. Third, California’s key export markets remain healthy. Exports from California-based firms increased 9.8 percent in the first half of 2006, after expanding 6.2 percent in 2005.
Industry Highlights
Real Estate: U.S. home sales are deteriorating, but remain at healthy levels by historical standards. However, home inventories are building up rapidly and home price inflation has diminished. Inventories are especially high in the condominium market, where there is an eight-month supply of unsold homes.
Builders are discounting new homes prices and providing other giveaways in order to turn over unsold homes, many of which result from cancelled orders by speculative buyers. Mortgage rates have declined of late as long-term Treasury yields have fallen. So far, the California real estate downturn has been more severe than the nation as a whole, but this was expected given the strength of the housing upturn in the state.
U.S. commercial real estate markets continue to improve and are providing an economic offset to the deteriorating residential real estate market. The EAC expects national industrial and office markets to maintain positive absorption trends in 2006.
Markets remained healthiest in Southern California, with Los Angeles County and the Riverside/San Bernardino area among the strongest markets in the United States. Northern California markets are not as strong, but have seen steady improvement in recent quarters.
Tourism: California’s tourism sector has remained strong, despite further increases in gas prices and airfares. Hotel occupancy rates have continued to rise and there is solid activity reported at key Northern and Southern California tourist and convention destinations. There is a considerable amount of hotel construction underway in the state, in large part to service the convention business.
Banking: The EAC continues to see declines in home equity lending and mortgage refinancing activity, nationwide and in California. Lending standards to household and businesses are still fairly lax, according to Federal Reserve surveys. This could change, as federal regulators will soon issue new guidance to mortgage lenders, which will limit creative financing techniques such as interest-only loans and option adjustable rate mortgages.
Commercial and industrial lending — which has lagged in the current business cycle — has gained increasing strength. The slowdown in consumer lending and the flat yield curve is beginning to weigh on bank profits, which have been heavily reliant on household sector lending.
Agriculture and Resources: California agriculture remains in good shape. Agricultural commodity prices remain firm, although the EAC noted exceptions such as dairy prices. Foreign demand for California agricultural products remains healthy. But agricultural profits have been increasingly squeezed by rising interest rates and increased costs of energy and labor.
California water supplies remain abundant following last year’s wet winter. Flood control and levee repair remain key state priorities, but action in these areas depends on voter approval of bond issues.
Electricity supplies look sufficient in the short-term due to some new capacity and rising electricity imports resulting from transmission line improvements. Still, California’s medium-and long-term electric reliability problems and peak-capacity issues are unresolved. Although investment in the electricity transmission system has improved, it is still below what is needed.
Risks
Risks to the outlook revolve around possible intensification of the three economic headwinds: rising interest rates, the softening housing market and high energy prices.
Following a recent pause, the Fed has left the door open for additional rate hikes. From a growth prospective, the Fed is already quite restrictive. A mild recession cannot be ruled out if the Fed Funds rate rises much further.
Possible hurricanes are also a threat to energy prices, with a significant portion of U.S. crude oil and natural gas capacity, and refineries, concentrated in the Gulf of Mexico region. The EAC has not seen a full recovery of Gulf oil and natural gas predication following last year’s hurricane damage, and the recent partial shutdown of Alaska’s Prudhoe oil field due to pipeline corrosion adds to energy supply vulnerability.
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Staff Contact: Dave Kilby