June 11, 2003 Federal Reserve Districts Third District--Philadelphia

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Economic conditions in the Third District were mixed in May; some sectors improved slightly and others remained weak. Manufacturers reported continuing declines in orders and shipments. Retail sales of general merchandise picked up during the Memorial Day weekend, although sales for the month as a whole were somewhat below the year-ago level. Auto sales improved in May from April but were below the level set in May of last year. Bank lending has been rising slowly, with relatively stronger gains in residential real estate lending and slight growth in consumer and business lending. Commercial real estate market conditions remained soft, with rising vacancy rates in some markets and falling effective rents. Residential real estate sales rose in May compared with April, and house price appreciation has been strong. Looking ahead, contacts in the Third District business community generally expect improvement in the coming months, although their views are mostly cautious. Manufacturers forecast some increases in shipments and orders during the next six months, but a significant number are considering reductions in production plans for the second half of the year compared with their earlier intentions. Retailers say the outlook is uncertain, and they do not expect significant improvement during the second half of the year. Auto dealers anticipate only a slight increase in sales from the current rate. Bankers expect continued slow growth in lending, mainly from residential real estate activity. Residential builders and real estate agents expect home sales this year to be about in line with last year's results or somewhat better, but commercial real estate agents do not anticipate any strengthening in office markets until next year. Manufacturing Orders and shipments at Third District manufacturing plants edged down in May compared with April, although the number of industrial firms reporting increases in new orders has risen recently and the number reporting decreases has fallen. However, the net improvement has been slight, and the trend in orders remained weak and order backlogs continued to decline. Manufacturers also continued to report declining inventories. Conditions varied among the major industry sectors in the region. Firms that make products used in residential construction reported rising orders, although some of the increase was said to be seasonal, and some makers of business and industrial equipment noted increased demand for their products. Declines in orders were reported among apparel makers, producers of basic industrial materials, and transportation equipment. On balance, the region's manufacturers forecast improvement. Over half of the firms surveyed in May expect increases in shipments and orders, and around one in ten anticipate decreases during the next six months. Although their outlook is positive, on balance, a significant number of area manufacturers appear to be trimming their expected production rates for the second half of the year relative to the plans they had made at the beginning of the year. Around half of the firms surveyed in May said they expect production in the second half to be consistent with their earlier plans, but more than 40 percent said they might reduce production rates compared with plans, and only a few firms are considering production rates above earlier plans. Capital spending plans among area manufacturers call for increases, on balance. About one in four of the firms polled in May have scheduled higher outlays during the next six months, but the proportion of firms reporting they will reduce capital spending has risen recently, to nearly one in five of those polled in May. Retail Third District retailers generally reported that current dollar sales in May were below sales in May of last year, despite a pickup during the Memorial Day weekend. Retailers indicated that store traffic has improved, but their revenues were being kept in check by falling prices for many lines of merchandise as well as by cautious consumer shopping. Merchants said sales of spring apparel have increased, but sales of other seasonal merchandise have been hampered by unseasonably cold and wet weather. Store executives said they were fully stocked for the start of the summer sales season, but they were limiting inventories in light of the lackluster sales pace so far this year. Most of the retailers contacted in May expect the second half of the year to be challenging. They said consumers are unlikely to step up spending significantly until employment conditions improve. With cautious views of sales this year, retail companies in the region have generally trimmed expansion plans for the year compared with their average rate of store openings and remodelings in the past few years. Auto sales in the District picked up slightly in May compared with April, but dealers said sales in both months were fewer than in the same months last year. Inventories have risen above desired levels for most dealers. Some domestic manufacturers are adding new incentives, but dealers generally expect this will produce only a slight boost in sales, at best. Finance Outstanding loan volume at Third District banks rose slowly in April and May. Residential real estate lending continued to move up, and depository institutions and mortgage companies reported a heavy rate of applications for both refinancings and purchase mortgages. Consumer credit also continued to expand. Commercial banks in the District reported slight gains in business lending, on balance. Several commercial loan officers said they expected commercial loan quality to slip in the second half of the year, as many of their business borrowers were not achieving the revenues they had forecast. Looking ahead, bankers in the Third District expect continued, although slow, growth in total lending. Bankers said possible further declines in interest rates might extend growth in residential lending, but they do not expect commercial lending to strengthen until business profits improve. Some bankers also said that further declines in loan interest rates will negatively affect their banks' interest margins because they cannot reduce deposit rates without experiencing deposit outflows. Real Estate and Construction Recent surveys by commercial real estate firms in the Third District indicated that overall office vacancy rates have edged up in suburban markets, where new buildings have recently become available, although the vacancy rate in the Philadelphia central business District has been nearly steady. Vacancy rates in suburban markets were estimated in a range of approximately 12 percent to 21 percent, up around 1 percentage point to 2 percentage points since the start of the year. The office vacancy rate in the Philadelphia central business District was recently estimated at around 13 percent, unchanged since the start of the year. Quoted rents remained fairly stable, but effective rental rates continued to decline as landlords offer tenant improvement allowances and rent-free periods. Leasing activity has been soft throughout the District, but there has been an increase in purchases of top-rated buildings in the Philadelphia central business District by real estate investment firms. Commercial real estate contacts say markets are likely to remain soft through the rest of the year, but they expect demand for space to begin growing sometime next year if economic conditions improve and area firms start to increase employment. Local commercial real estate brokers expect rents to rise, perhaps significantly, once demand for space turns up. Residential real estate agents and home builders generally reported that sales have been running higher in May than in March and April. Price appreciation for new homes continued to be strong in many parts of the region, especially in areas where land available for development has been limited. Price appreciation for existing homes remained rapid also, as the inventory of homes for sale has declined. Real estate agents had been expecting a slight drop in sales of existing homes this year compared with last year, but the continuing decline in mortgage interest rates has led some to predict that home sales this year could match last year. Homebuilders have mixed views: some expect their sales this year to equal or exceed last year's sales, but others said their ability to increase sales will be constrained by scarcity of land and limitations on development. Return to top New York Cleveland