April 28, 2008

ECONOMIC NEWS: Confidence Falls On High Prices, Housing Woes

Consumer confidence falls to quarter century low.  The University of Michigan/Reuters Consumer Sentiment Survey reported that consumer confidence fell to a revised 26-year low for the month of April.  The Index of Consumer Sentiment was revised to 62.6 from a preliminary estimate of 63.2 and a March value of 69.5.  In this month last year, the index was at 87.1.  Confidence has plunged lately as consumers have faced higher gasoline and food prices as well as stagnating incomes and decreased housing wealth.  The index had previously reached these lows when the US was in the midst of its second recession in the 1980s.

Sales of new homes plummet. Sales of new single-family homes fell 8.5 percent in March, to 526,000, from 575,000 in February. New-homes sales were 36.6 percent lower than March of last year, when sales were 830,000. New home sales are at their lowest point since 1991. The U.S. Census Bureau and the Department of Housing and Urban Development also jointly reported that the median sales price for new homes was $227,600 last month. The inventory of new homes is at an 11 month supply, which represents the largest inventory since 1981. (See Chart)

Existing home sales keep falling. The National Association of Realtors reported that existing home sales in March were down 2 percent to a seasonally adjusted annual rate of 4.93 million units. This represented a decline from the 5.03 million units that were available in February. This month’s numbers are 19.3 percent below last year’s figure of 6.11 million.  The median price for any type of existing home was $200,700 in March, which was 7.7 percent below last year’s median price of $217,400. Moreover, the median price of a single-family home fell 8.3 percent from last year, to $198,200.

IN FOCUS: High Commodity and Food Prices

Food prices are up dramatically.  In the first three months of 2008, the Consumer Price Index for all Urban Consumers (CPI-U) for food rose by 5.3 percent on an annual rate, far more rapidly than the overall CPI-U, which rose at a 3.1 percent annual rate.  Because food takes up an appreciable part of household budgets – approximately 12.6 percent of the expenditures of the average household – there is widespread interest in explaining this price behavior.

There are several reasons behind the recent rise in food prices.  The first points to changes in economic fundamentals.  High energy prices make agricultural production more expensive by raising the cost of mechanical cultivation, inputs like fertilizers and pesticides, and transportation of inputs and outputs.  Additionally, with oil prices at an all-time high of more than $100 per barrel and government subsidies to farmers to grow crops for energy, as well as mandates to replace a specified percentage of gasoline with ethanol in the Energy Policy Act of 2005, U.S. farmers have shifted their cultivation toward biofuel feedstocks, especially corn, often at the expense of soybean and wheat cultivation. About 30 percent of U.S. corn production will go into ethanol in 2008 rather than into world food and feed markets.

Moreover, commodity markets are global; supply reductions in other countries translate to higher prices paid in U.S. markets.   Droughts in Australia and Eastern Europe and poor weather in Canada, Western Europe, and the Ukraine have reduced production at a moment when world stocks of grain are at historically low levels relative to demand.

The other explanation is the rise in commodity market speculation, which has been stimulated by low real interest rates.   Some economists argue that low real interest rates lower the cost of carrying inventories and increase the attractiveness of speculating in commodities relative to holding Treasury bills.  In addition, low interest rates may convince some investors that higher inflation is on the way, encouraging them to invest in commodities as an inflation hedge.

Recently, low real interest rates have coincided with high commodity prices. (See Snapshot)  Indeed, there is systematic research that supports this connection.  For example, Frankel found that, historically, years where the real interest rate was lowest tended also to be years in which commodity prices were high relative to other prices.  (See "The Effect of Monetary Policy on Real Commodity Prices" in Asset Prices and Monetary Policy, John Campbell, ed., U. Chicago Press, 2007.)

Other factors are affecting demand for U.S. agricultural products.  Higher incomes and growing urban populations are boosting demand for meat and highly processed food in developing countries such as India and China.  These changes have increased demand for feed grains and edible oil.  Moreover, as the dollar depreciates against foreign currencies, U.S. products become relatively less expensive, in turn boosting demand.

Sorting through these explanations is no easy matter, but anyone thinking about possible policy responses to food price movements needs to understand them.  The Joint Economic Committee’s hearing on Thursday, May 1st at 10 AM in 216 Hart will provide expert analysis of these issues and government action going forward.

ECONOMY AT A GLANCE