September 5, 2007 Federal Reserve Districts Third District--Philadelphia

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Business activity expanded in the Third District in August, although the pace of expansion appeared to ease somewhat. Manufacturers, on balance, reported increases in new orders and shipments, although the number of firms reporting increases declined from a month ago. Retailers generally reported year-over-year gains in August in line with previous months, although some stores had weaker than expected sales. Auto sales improved slightly from July to August but remained below the level of a year ago. Overall bank lending rose slightly, with gains in business and personal lending, but residential mortgage activity declined. Residential real estate demand has weakened considerably since our last report, but demand for commercial real estate has remained strong. Firms reporting on labor costs generally noted moderate, steady rates of increase in wages, but several said increases in non-wage benefits costs were large. Firms reported increases in input costs and output prices in August, although the extent of the increases did not appear to have changed much since July. Third District firms generally foresee continued growth in the next few months, although several contacts said they expect the rate of growth to ease. Manufacturers expect some increases in demand for their products in the months ahead, and, except for some manufacturers of building products, they have plans to increase capital spending. Retailers generally expect sales to increase at their current rate. Auto dealers are not certain of the near-term outlook, although they expect sales for the year as a whole to be below those of last year. Bankers anticipate further growth in business and personal lending, albeit at a slower pace, but they expect residential mortgage lending to decline. Home builders and residential real estate agents expect sales to remain slow. Most contacts in commercial real estate anticipate continued strong demand for office and industrial space, but several contacts believe office construction activity could decline late this year and into next year. Manufacturing Third District manufacturers, on balance, reported increases in shipments and new orders in August. Around one-third of the manufacturers surveyed noted increases and around one-fifth noted decreases. However, compared with the previous month, fewer firms reported increases and slightly more reported decreases. Order backlogs, overall, were unchanged from July to August. Firms producing apparel, chemicals, and industrial equipment reported increases in orders in August, but firms producing lumber, building materials, and transportation equipment reported decreases. Half the manufacturing firms contacted for this report expect increases in new orders and shipments over the next six months, and only a few expect decreases. Firms in most of the major manufacturing industries in the region have scheduled increased capital spending in the next six months, although makers of wood and metal products have trimmed planned capital expenditures. Retail Retailers in the Third District reported that sales in August picked up for back-to-school shopping. Most indicated that the year-over-year gain was similar to the annual increases that were posted in previous months. However, some apparel specialty stores noted weaker gains. Merchants also said sales of consumer durable goods, particularly appliances and home furnishings, have slackened. Some store executives said price discounting increased during the back-to-school shopping period compared with spring and early summer. Retailers expect sales to increase in the months ahead at around the current rate, although several of those contacted for this report said the outlook is becoming more uncertain, and some said they were putting expansion plans on hold. Auto dealers in the region generally reported a slight pickup in sales from July to August, but they are uncertain that the higher rate of sales will continue. Most expect sales for this year as a whole to be below those of last year. Foreign makes continued to have better year-over-year sales comparisons than domestic makes, and dealers believe reorganization and other managerial changes at domestic manufacturers could hamper marketing efforts and limit possibilities for increasing sales of their vehicles. Consolidation and closings of dealerships continue, mainly for domestic makes. Finance The volume of outstanding loans at Third District banks remained on a slight upward trend in August, according to lending officers contacted for this report. Loan growth is mainly in business and credit card lending. Demand for residential purchase mortgages has declined, but refinancing applications have increased as borrowers seek to switch from adjustable-rate to fixed-rate mortgages. Demand for home equity loans has been gaining, but the rate of expansion has eased, according to some of the bankers surveyed in August. In general, bankers noted slight increases in delinquencies on mortgages and credit cards. Looking ahead, bankers foresee continued growth in business and personal lending, although many expect the rate of increase to be slower in the next several quarters than it was in the first half of the year. Virtually all contacts concerned with residential mortgage lending expect activity to remain slow for the rest of this year and into next year. Contacts in secondary debt markets reported a sharp drop-off in demand for collateralized debt obligations in mid-August affecting securities backed by residential as well as commercial real estate debt. Contacts said that concern about underlying credit quality has risen among investors in collateralized debt obligations. However, some contacts reported that further decreases in prices would probably prompt purchases of secondary market securities that can meet more critical scrutiny for risk. Despite any possible improvement in secondary markets, however, most contacts do not expect the residential mortgage origination business to rebound soon. Real Estate and Construction Residential real estate activity has slowed dramatically since mid-summer, according to home builders and real estate agents contacted in late August. The sales rate for new homes has declined by half or more, according to some builders, and cancellations have increased. Builders reported making large price reductions with little effect on sales. Sales of existing homes have also dropped. Inventories of existing homes for sale remain high, but the rate of new listings has slowed. The falloff in sales of both new and existing homes has occurred in nearly all parts of the region, including areas that had recently experienced strong sales. Contacts among builders and real estate agents do not expect a quick turnaround. Several said they expect housing demand to remain subdued for a year or more, even if mortgage credit becomes more readily available. Commercial real estate firms report that office vacancy rates in the region have continued to decline over the past several months, and rental rates have increased. Demand for office space has grown as firms in the region have expanded. Although new buildings have added to available space, conversion of older buildings to other uses has removed some space from office markets. Construction is up in many office markets in the region, on both a build-to-suit and a speculative basis. Industrial real estate firms report that overall demand for industrial space remains strong. Vacancy rates have moved down and rents have risen moderately. Construction of industrial buildings has increased. Looking ahead, some contacts in the commercial real estate sector are not certain that construction of commercial buildings will continue to rise, but several contacts indicated that they expected public infrastructure construction to pick up, mainly for roads and bridges and for utilities. Prices and Wages Reports of increases in input costs and output prices from Third District business contacts were about as prevalent in August as they were in July. Grain prices have been rising, leading to higher prices for meat and bakery products. Prices of some metals, chemicals, and industrial machinery were also reported to be increasing. In contrast, prices of lumber and wood products were reported to be easing. Price discounts to boost back-to-school sales were fairly common among retailers, limiting the year-to-year increase in effective prices of much seasonal merchandise. Most of the firms reporting on employment costs in August indicated a continuing trend of moderate wage increases. Several firms noted that increases in benefit costs continued to be large, although not accelerating. Nevertheless, employers in the region said they were continuing to look for ways to reduce benefit costs. Return to top New York Cleveland