Overview:

While the economy expanded at a surprisingly strong pace of 3.3 percent in the second quarter, it resulted in no net gains in employment, causing the unemployment rate to trend up.  Nonfarm payroll employment fell in August for an eighth consecutive month, declining by 84,000.  In addition, June and July job losses were revised up by a total of 58,000 jobs.  Since the beginning of the year, 605,000 jobs have been lost -- an average of about 76,000 jobs per month.  Job losses worsened in the second quarter, averaging 72,000 per month, compared with an average of 37,000 per month in the first quarter.

The unemployment rate, which is calculated from a separate survey, jumped from 5.7 percent in July to 6.1 percent in August -- the highest level since September 2003.  Jobs were lost in every private service industry except education and healthcare services.   Manufacturers cut 61,000 jobs -- the biggest since July 2003.  Construction job losses decelerated, with builders shedding 8,000 jobs -- the smallest drop since June 2007. 

After posting slight increases in the previous two months, mortgage industry employment resumed its decline in July, losing 2,100 jobs to 356,400. (The Bureau of the Labor Statistics releases some detailed categories of employment with a one-month lag.)  Since April, the industry’s employment was little changed, hovering between 356,000 and 358,500.  Since its peak in February 2006, the industry’s employment has declined by about 30 percent.

Other reports this week confirmed the view that economic growth will slip to a subpar pace in the third quarter as the impact of the stimulus checks fades and global growth slows.  Construction spending fell in July, with private nonresidential construction spending dropping for the first time this year.   A survey from the Mortgage Bankers Association showed that mortgage credit quality continued to deteriorate in the second quarter.   Surveys from the Institute for Supply Management (ISM) showed that manufacturing activity declined for the first time in three months in August, while service activity expanded for the first time in three months. 

Finally, good news on inflation continued this week.  With a significant upward revision in economic growth in the second quarter, unit labor costs -- a gauge of wage pressures -- were revised down to show a decline of 0.5 percent in the second quarter from an earlier reported increase of 1.3 percent.  This indicates an absence of inflationary pressures from the labor markets, given strong labor productivity and the slack in the markets.  Both ISM surveys also indicated that the prices firms paid for raw materials continued to decline.  This trend will likely continue in the near term.  Crude prices declined more than 8 percent this week, the largest since July, as the dollar rose to the highest this year against the euro.  All these developments, coupled with accelerating job losses, suggest that the Federal Reserve will likely keep interest rates on hold through the rest of the year.

Interest Rates:

Economic data were largely negative on economic growth this week, rattling investors, resulting in stock market declines on growth concerns.   Treasuries rallied as investors shunned risk and yields steadily declined throughout the week.  The yield on the 10-year Treasury note stayed around 3.54 percent by mid-Friday afternoon -- 29 basis points lower than the rate on the previous Friday and the lowest rate since mid-April.  This is good news for near-term mortgage demand.  Unless the spread between the yields on 10-year Treasury notes and conforming fixed-rate mortgages widens further from the current gap of about 260-265 basis points, as large as that seen during the Bear Stearns crisis, mortgage rates should see a meaningful decline in the coming week.  Thirty-year fixed rate mortgage yields averaged slightly less than 6.4 percent this week after declining for three consecutive weeks.

Housing and Mortgage Indicators:

Total construction spending fell 0.6 percent in July, following a 0.3 percent increase in June.  A 1.4 percent increase in public construction spending more than offset a decline in private construction spending.

Private residential projects declined 2.3 percent in July to the lowest level since March 2001, driven by a 2.3 percent decline in private residential construction spending.  Private nonresidential construction spending also fell 0.7 percent. 

From a year ago, private residential construction spending has declined 27.5 percent.  By contrast, private nonresidential construction spending was up 16.0 percent over the past year.  Residential investment will likely be a drag on economic growth again in the third quarter.  During the second quarter, residential investment subtracted 0.6 percentage points from gross domestic product -- the smallest drag in a year. 

The Mortgage Bankers Association National Delinquency Survey showed that delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 6.41 percent of all loans outstanding at the end of the second quarter of 2008, up six basis points from the first quarter of 2008.  The increase in the overall delinquency rate was driven by increases in the number of loans in California and Florida. 

The percentage of loans in the foreclosure process at the end of the second quarter was 2.75 percent, an increase of 28 basis points from the first quarter of 2008 and 135 basis points from one year ago.   The percentage of loans on which foreclosure actions were started during the second quarter was 1.08 percent, up 7 basis points from last quarter and up 49 basis points from one year ago on a non-seasonally adjusted basis.  Once again this quarter, the rate of foreclosure starts and the percentage of loans in the process of foreclosure set new records.

Subprime ARM loans accounted for 36 percent of all foreclosures started and prime ARMs, which include option ARMs, represented 23 percent.  However, the increase in prime ARMs foreclosure starts was greater than the combined increase in fixed-rate and ARM subprime loans.  Thus the foreclosure start numbers will likely be increasingly dominated increasingly by prime ARM loans.

Economic Indicators:

The Institute for Supply Management (ISM) Manufacturing Index indicated that manufacturing activity contracted in August, with the index edging down to 49.9 from 50.0 in July.  A reading above 50 indicates an expansion in the manufacturing sector. 

The ISM manufacturing index is based on a survey of purchasing executives at roughly 300 industrial companies.  It includes nine different sub-indices: new orders, production, employment, supplier deliveries, inventories, prices, new export orders, imports and backlog of orders.

New orders rebounded to 48.3 from the prior month’s reading of 45.0, which was the lowest since October 2001.  The production index edged down to 52.1 from 52.9 in July.  Strong demand for capital goods overseas continued to support manufacturing activity, as new export orders jumped three points to 57.0.   Weakness in manufacturing employment persisted, with the employment index declining 2.2 points to 49.7.

The latest ISM report contained good news on the inflation front, with the prices that manufacturers paid for inputs dropping for the second consecutive month.  The prices-paid index fell 11.5 points to 77.0.   This was the largest month-to-month decline in the prices paid index since October 2006 and reflects the sharp decline in energy and other commodity prices -- main raw materials used by manufacturers.

The ISM Nonmanufacturing Index rose to 50.6 in August from 49.5 in July.  This is the first time in three months that the index showed a reading above 50, indicating an expanding service sector. 

Both the production and new orders indices increased moderately.  However, the employment index fell to the reading that was about two points above the record low set in June.   Other negatives included a surprising decline in the export index to a reading that matched its record low set in October 2001. An increase in the customer inventories index to a very high level was also discouraging.

The survey offered an improving inflation picture, showing declining prices firms paid for raw material for a second consecutive month.  In June the index reached the highest reading since the inception of the survey in 1997.  This reflected declining oil and commodity prices and was consistent with the trend in the ISM manufacturing survey.

Factory orders rose 1.3 percent in July following a 2.1 percent increase in June.   Durable goods orders rose 1.3 percent, unchanged from the previously released figure, while nondurable goods were up 1.2 percent.

Nonfarm productivity, a measure of output per hour, increased by 4.3 percent (annualized rate) in the second quarter, almost doubling the initial estimate of 2.2 percent.  Much of the sharp upward revision was due to an upward revision to output growth.  At the end of July, the Bureau of Economic Analysis revised upward an estimate of real gross domestic product growth in the second quarter to 3.3 percent from 1.9 percent.  The hours worked measure saw a decline of 0.8 percent in the second quarter, compared with a 0.5 percent drop reported earlier.

From the second quarter of 2007 to the second quarter of 2008, productivity increased 3.4 percent.   This was the strongest year-over-year productivity growth in four years.

With the large upward revision to output, unit labor costs were revised substantially downward.   Unit labor costs declined 0.5 percent in the second quarter, revised down from an increase of 1.3 percent.  Unit labor cost growth in the first quarter was also revised downward to 1.2 percent from 2.5 percent.  These downward revisions helped keep the year-over-year gain in unit labor costs in the second quarter to only 0.6 percent -- compared with growth of almost three percent in all of 2007. 

Nonfarm payrolls contracted by 84,000 jobs in August following declines of 100,000 and 60,000 in June and July, respectively.   Private sector job losses totaled 101,000.   Average hourly earnings rose 7 cents in August for the second consecutive month.   The over-the-year increase in earnings was 3.6 percent compared with 3.4 percent in July.   The average private sector workweek was unchanged at 33.7 hours for the third consecutive month.

The unemployment rate jumped from 5.7 percent to 6.1 percent.  The rate was up 1.44 percentage points from a year ago.   The increase was driven by an increase in the adult unemployment rate (over 18 years of age), which rose from 5.0 percent to 5.5 percent.   This is different from a few months ago, when the unemployment rate was being boosted by increases in the volatile teenage unemployment rate boosted the increase in the overall unemployment rate.  The unemployment rate for teenagers fell from 13.4 percent in July to 13.1 percent in August.

Next Week:

Tuesday — The National Association of Realtors Pending Home Sales Index

Thursday — August import prices

Friday — August Producer Price Index (PPI); August retail sales; and the preliminary estimate of the University of Michigan’s Survey of Consumer Sentiment for September

Orawin Velz

Associate Vice President, Economic Forecasting

September 5, 2008