As newer technologies work their way through the supply chain, output per hour is expected to reaccelerate in late 2006 and 2007. A recent survey by the Institute for Supply Management suggests that companies have yet to tap the potential of the equipment that was just installed. As of December, 80% of manufacturers were less than three-fourths complete in achieving the efficiency of existing technologies; 46% were less than half complete.

Firms are also more actively engaging their workers in leveraging those technologies, which is resulting in even larger returns on investments. For example, manufacturers in the Midwest are turning to their line workers not only to solve production problems, but also to design better distribution centers. As a result, problems on plant floors are being solved within hours instead of weeks–worker buy-in to technology changes has also improved. All this will be necessary to offset pressure for rising wages as the labor market tightens.

And there may be room for even more improvement. Work done by researchers at the Federal Reserve Board suggests that the level of business investment is still lagging. This means that we would need to see an extended period of accelerated investment gains in order to restore the capital stock to a level that is more consistent with historic norms.

INFLATION
By M. Cary Leahey, Decision Economics Inc.

Consumer price inflation has begun to rear its ugly head, although admittedly from a low base. The headline CPI inflation rate has averaged 5.1% so far this year, up from the 3.4% pace of the previous two years. Even the core rate, which excludes volatile energy and food prices, has edged up to an annualized 3.1% so far in 2006 from the 2.2% at which it seemed stuck in 2004 and 2005. While commodity prices have been notably stronger for years, wage inflation has now begun to show signs of accelerating, too, as the labor market shows signs of tightening.

Fortunately, given the current headaches with oil and many raw materials, the bulk of the historical evidence suggests that commodity prices have a very small impact on long-term inflation. But about two-thirds of business costs are attributable to the price tag for labor, defined as total compensation relative to productivity gains. Thus, coupling the two can easily become a self-fulfilling prophecy for significantly higher inflation as companies and workers begin to expect higher inflation, and policymakers around the globe now see it as their job to preempt, rather than simply respond to, such a deleterious mindset.

At 4.6%, the unemployment rate is quite low by historical standards and suggests continued upward pressure on wage and price inflation. Most forecasters, including Decision Economics, expect core CPI inflation (excluding food and energy costs) to accelerate to 2.5% this year from 2.2% in 2005. Like the Fed, we look for enough of a slowdown later this year to help cool off inflation back toward 2% next year. If so, this year's acceleration in inflation will be a relatively transitory event, as long as inflation expectations remain well anchored.

Fed Chairman Bernanke has been hinting in recent weeks that the Federal Reserve Board is ready to pause and slow the pace of tightening since members think that core inflation will soon be cresting. History indicates that this is standard operating procedure at the Fed: In 1989, 1995, and 2000, the Greenspan-led Fed stopped tightening interest rates before core consumer price inflation had crested, as shown in the chart.

But what will Bernanke and his colleagues watch for guidance? A little something called the core personal consumption expenditures (PCE) price index, which tends to move closely with the core CPI. Currently, core PCE inflation is about one-quarter of a percentage point below the core CPI and has averaged 1.7% in the last 10 years and 2.5% in the last 20 years. Given that the Fed's own informal band of inflation confidence is between 1% and 2%, with the midpoint obviously at 1.5%, the danger here is that Bernanke, as the new policymaker on the block, may find it difficult to determine when to take his foot off the brake in the face of continuing pressure on prices over the next two quarters.

It may very well be that the natural resting place for that core inflation today is 2% and not 1.5%, and to lower the economy's inflationary center of gravity may require more restrictive interest rates for a longer period of time than many analysts and investors are willing to swallow, increasing the risks of a hard landing.

THE HOUSING BUBBLE
By Ian Shepherson, High Frequency Economics

The housing market has already slowed considerably, but alas, you ain't seen nothing yet. After 15 years of almost uninterrupted increases in the volume of transactions and home prices, the stage is now set for an extended correction.

The key problem facing the market is that oversupply of both new and existing homes for sale is now depressing the rate of increase of home prices. Homes are expensive to buy, sell and maintain, so investors need to be confident that future price gains will be robust.

This was a perfectly reasonable assumption over the past few years, but as homebuilders started to believe their own hype, they killed the golden goose. The number of new homes for sale now is some 24% higher than a year ago, and the first rule of economics is that increased supply means lower prices, other things equal. But other things are not equal, because mortgage rates are now 1.25 percentage points higher than a year ago, so the market is being squeezed from both sides.

As price gains slow, the implied real mortgage rate rises. As recently as late last spring, you could borrow on a 30-year fixed rate mortgage at about 5.5% and buy a home appreciating at about 11.5% per year, so the real mortgage rate was –6%. This was a big incentive to borrow more and buy a bigger house. In fact, why not buy two? Plenty of people did, and speculative activity in the market soared.

The national average 30-year fixed mortgage rate is now about 6.75%, and expectations are now for home price declines and not increases, so it no longer makes sense to buy property to make a quick killing. Even if buyers expect a static market on home prices, the implied real mortgage rate is now plus-6.75%, rather than a negative.

At their peak in the summer of last year, home sales were running about 45% higher than the long-term average. The only comparable peak was back in 1978, after which home sales dropped for four straight years, toppling by a total of 55% from peak to trough. I doubt the correction this time will be quite so big, but if real mortgage rates are as high as I believe them to be, it would be reasonable to expect sales to drop a further 30% or so on top of the 7% decline already recorded since last summer.

As housing transactions volumes fall, the construction industry will contract. At the bottom of the last housing cycle, construction of new homes accounted for 3.3% of GDP. In the first quarter of this year, that had swollen to 6.4% of GDP, far above the long-run average of 4.5% of GDP. In the past, serious corrections have always seen the sector shrinking back below trend. I don't expect anything different this time, so the impact on construction could well be enough to reduce GDP by about 3%, probably spread over a couple of years.

Retailers will be hurt, too. A substantial piece of retail activity, including spending on building materials and furniture, is driven by the strength of the housing market. With the volume of transactions set to drop and the end to big price gains crimping home equity extraction, it is not hard to imagine retail activity taking another 1% off GDP over the next couple of years.

Putting the two elements together, it is easy to see that the housing correction could be a serious drag on the economy for some time to come. Not enough alone to cause a recession, but certainly enough to hurt.