Smith Faculty Opinion Article - October 27, 2005

Unemployment Claims, Falling Home Prices
Indicate Raising Interest Rates Poses Big Risks
By Dr. Peter Morici, Professor of International Business

Evidence is mounting that Hurricanes Katrina and Rita delivered a body blow to an already slowing U.S. economy. Unemployment claims continue to mount, prices for existing houses are falling, and retail sales have been tepid. All these point to the peril of raising interest rates too much further.

Today, the Department of Labor reported Initial Weekly Unemployment Insurance Claims was 328,000 for the week ending October 22 and the four week moving average is 366,500. In September and October, initial jobless claims have been running 94,500 per week ahead of the four weeks immediately preceding Hurricanes Katrina and Rita. If trends continue through the final week of the month, Katrina and Rita will add about 185,000 to the jobless rolls in October, on top of the approximately 200,000 lost in September.

Next week, the Labor Department will report October employment gains and unemployment. Although some jobs lost to Katrina and Rita will be offset by those added to aid in relief and rebuilding, the data at hand indicate that employment growth has not nearly recovered to pre-Katrina levels in October. Unemployment will likely rise to 5.2 percent but that figure will importantly depend on how many workers quit the labor force in the aftermath of Katrina and Rita.

Tomorrow, the Commerce Department will report third quarter GDP growth. Thanks largely to pre-Katrina employment gains in July and August, third quarter GDP growth should be about 3.3 percent. Job losses inflicted by Katrina and Rita in September and October indicate GDP growth will slow to about 2.9 percent in the fourth quarter. Overall, Katrina and Rita will reduce GDP growth by 0.3 percent in the third quarter and 0.7 percent in the fourth quarter.

In the past, GDP and wage loses from disasters like Katrina have been regained in future quarters but the scope of devastation makes that unlikely. The U.S. economy will likely never regain half the lost growth.

Borrowing against home equities and credit card debt gave the economy a considerable lift over the past three years; however, the string appears to be running out. Since June, consumer spending has exceeded household incomes, prices for existing homes are falling and credit card delinquencies are nearing 5 percent. Retail sales growth has been stagnant in recent months.

According to the National Association of Realtors, from August to September, sales of existing homes were unchanged and the median sale price was down $8000 in September, about 3.6 percent. Also in September, inventories of unsold homes were up for the sixth consecutive month, and the median sales price is at its lowest level since June.

Falling home prices and rising credit card delinquencies are contributing to lackluster retail sales and pessimism for the holiday season, especially among middle-range retailers. Wal-Mart will do well hawking discounted goods to ordinary folks and Neiman Marcus will hustle its high-end accessories to the well off, but the Sears and Macys will struggle. The hour glass economy will narrow yet more around the middle.

Some businesses are trying to pass higher energy costs into prices for final goods and services but these efforts are likely to be frustrated. Consumer prices, less energy and food, may rise in October but these are likely to fall in November and December. Early reports for auto sales in October indicate attempts by General Motors, Ford and Chrysler to escape discounting have failed. They will have to cut prices to clear inventories.

Gasoline, natural gas and other petroleum prices have been easing back and productivity gains seem more than adequate to absorb higher material costs. Count on competition, not monetary policy, to discipline prices.

In this environment of rising unemployment, slower growth, falling housing values and energy prices, and consumer credit squeezed to near its limits, further interest rate increases could send the economy into a tailspin. Household liquidity is perilously thin. Housing and auto are particularly vulnerable, and panics in these sectors could throw much of the consumer sector into the abyss.

Prudent hurricane relief and cautious management of monetary policy could bring the economy back nicely in 2006. However, should the Fed persist in pushing interest rates up to 4.5 percent as many expect, it risks pushing the economy into a recession.