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Federal Reserve Districts

Third District--Philadelphia

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Economic activity in the Third District grew at a slow pace in February. Manufacturers reported increases in shipments and new orders during the month. Retail sales of general merchandise rose, but the year-to-year gain was slight. Auto sales increased marginally from January to February, but fell on a year-over-year basis. Bank lending has been increasing, although demand for residential mortgages has declined. Commercial real estate markets continued to tighten, but residential real estate activity eased.

Third District business contacts generally expect business activity in the region to continue to expand at a modest rate. Manufacturers expect growth in business to accelerate somewhat from the current pace, and they are scheduling a slight increase in capital outlays. Retailers anticipate a small gain in sales in March and somewhat faster growth in April. Auto dealers anticipate slower sales this year than in 2005. Banks and other lenders expect business and personal lending to increase, but they forecast a decrease in residential mortgage lending. Contacts in commercial real estate generally expect further declines in vacancy rates and a firming in rents. Residential real estate agents and home builders anticipate slower sales for the balance of the year compared with the same period last year, and they expect the rate of home price appreciation to ease.

Manufacturers in the Third District reported increased demand for their products in February. Slightly more than one-third of the companies contacted said that shipments and new orders rose from the previous month; about one-fifth reported a decline. On balance, area manufacturers saw an upturn in order backlogs. The improvement in conditions during February followed sluggish growth in January. Among the District's major manufacturing sectors, business improved in February for producers of industrial and construction materials, lumber, metals, and electrical equipment, but was about steady in other sectors.

Overall, manufacturers expect growth in business activity to pick up in the months ahead. Half of the firms contacted in February expect their shipments and orders to increase during the next six months; about one-tenth expect decreases. On balance, capital spending plans among District manufacturers call for slightly stepped-up expenditures. The largest increases in capital spending are being planned by producers of metals, industrial materials, machinery, and electrical equipment.

Most of the retailers contacted for this report indicated that sales growth slipped in February from the pace in January. Overall, sales of general merchandise were up just slightly in February compared with the same month last year. Retailers said sales in January got a boost from the redemption of gift cards purchased for Christmas and from warm weather that encouraged shopping. A return to more normal winter temperatures in February helped sales of winter apparel but otherwise had a negative effect, according to area merchants. Despite the sluggish growth in sales, store executives said their inventory levels were not excessive. Third District merchants expect the rate of sales growth to remain slow through March, then pick up in April as a result of the late date on which Easter falls this year. However, some store officials said March sales could be exceed their current expectations if temperatures rise above seasonal norms.

Auto sales in the region rose slightly in February, although they were below the level of February 2005. Area dealers gave mixed reports, indicating that foreign models continued to have better year-to-year sales comparisons than domestic models. Dealers have kept inventories in check, limiting their orders to manufacturers. On balance, area dealers expect sales this year to be below those of last year, but they are uncertain of the amount of the decline.

The volume of loans outstanding at Third District banks edged up in February from January, according to commercial bank lending officers contacted for this report. Commercial and industrial lending increased for most banks. Reports on consumer lending were mixed; some banks posted growth for the month, but others had declines. Demand for residential mortgages at banks and other financial institutions softened. Banks and other lenders in the region indicated that competition for loans continues to be strong. On the funding side, some banks have experienced deposit outflows, and several banks said they have raised deposit interest rates to maintain deposit growth. Banks as well as nonbank lenders reported that their net interest margins have decreased, reducing their overall profit margins. Bankers in the District expect slow growth in lending in the months ahead. In general, bankers expect growth in commercial and industrial lending, although several banks indicated they were limiting growth in lending for real estate development and construction. Most bankers and other lenders contacted for this report expect a further decline in demand for residential mortgages.

Real Estate and Construction
Commercial real estate firms reported that vacancy rates in the region's office markets have continued to fall in the past few months. Rents have edged up generally in response to growing demand, although owners of older buildings have been upgrading and renovating them in order to compete with recently constructed buildings. Commercial real estate contacts expect further gradual tightening of the region's office markets this year. However, the supply of office space in the region will increase during 2006 as buildings under construction are completed and a large number of leases in existing buildings expire. Some commercial real estate agents believe the increased supply could limit the rise in rental rates unless demand picks up as well. Demand for industrial space in the region has been growing, with significant increases in leasing and purchasing, and rising rental rates.

Residential real estate agents and homebuilders generally reported a slowing in sales in February, compared with the pace set earlier this winter and with sales in February of last year. Some real estate contacts noted that the number of existing homes for sale has risen and the time they are on the market has increased. Homebuilders and real estate agents expect sales this year to be lower than in 2005, and they expect price appreciation to slow significantly.

Prices and Wages
Business firms in the Third District reported that they face continuing increases in costs of materials and intermediate goods, although the rate of increase does not appear to be accelerating. Manufacturers continued to face price increases for metals, petroleum-based products, and natural gas. Construction firms reported tighter supplies and higher costs for steel, cement, and products made of PVC, plastic, and gypsum. Prices have also increased for coal and asphalt. Firms in all industries continued to report increases in the cost of employee health benefits.

Employers in a range of industries reported that labor markets have tightened, noting that they have had more difficulty attracting and retaining qualified workers at all skill levels. Employee turnover has increased, and several firms surveyed for this report indicated that they have stepped up counteroffers in order to keep employees from leaving. Firms report that average salaries and wages will increase somewhat more this year than last year, but they are likely to boost salaries significantly for critical positions.

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Last update: March 15, 2006