Thinking about higher interest rates and the demand for money

The Fed has raised rates and the market expects there will be at least 2 or 3 more rate hikes over the course of the next year. This has resulted in a significant increase in market rates of late. Fortunately, the economy is in pretty good shape, thanks to strong corporate profits and a booming AI industry. Housing is the one sector that is threatened, but that's not all bad, because a weak housing market could lead to more affordable prices, lower interest rates, and downward pressure on inflation.

Chart #1

Chart #1 is good evidence that the recent rise in interest rates is not due to higher inflation expectations which have been flat for the past four years or so. What's changed is that real yields have been rising. Why? Most likely because the market is sensing that economic growth is picking up. Stronger growth supports higher rates, and investors demand higher rates to compensate for more attractive returns on productive assets. 

Chart #2

Chart #2 compares ex-energy inflation to 5-yr Treasury yields. Clearly, this measure of inflation has very little influence on yields. I use ex-energy inflation because energy is by far the most volatile component of the CPI. What's important now is that interest rates are unquestionably high relative to underlying inflation, and this has important ramifications for monetary policy.

Chart #3

Chart #3 compares the year over year change in the CPI to a version of the CPI that excludes food, energy, and shelter costs. Food and energy costs have been strongly influenced by the Iran war disruptions, and shelter costs have been skewed higher for years because of faulty methods employed by the BLS. This measure of inflation is well-behaved and that in turn argues against further rate hikes.

Chart #4

Chart #4 compares the pace of economic growth (red line) to the real yield on 5-yr Treasuries (blue line). Real yields have a strong tendency to rise and fall as economic growth rises and falls.

Chart #5

Chart #5 uses a logarithmic scale to make it easier to identify underlying growth trends in real GDP. Note that in the past several years real GDP growth has been slowly trending higher vs the trend in place from 2009 through 2023. This partially justifies the recent rise in real yields. 

Chart #6

Chart #6 shows credit spreads on investment grade and high-yield corporate bonds. Spreads are relatively low, and that is consistent with a strong economy and a healthy outlook for corporate profits.

Chart #7

Chart #7 shows Bloomberg’s measure of financial conditions (positive values being good, negative values being bad). By this measure financial markets look quite healthy, and that again is consistent with a strong economy and a healthy outlook for corporate profits. 

Chart #8

Chart #8 shows how fixed-rate mortgage rates are strongly influenced by the 10-yr Treasury yield. Mortgage rates are now in the region of 7.5%, and that is putting a lot of pressure on the housing market. Housing is arguably the most threatened part of the US economy. Prices are relatively high, and with soaring interest rates, affordability is historically low. New home construction is weak, and that is keeping supply tight and that helps support prices. Something has to give, and I think it will be prices—which could fall significantly in coming years. Interest rates will likely decline as well, once the Fed realizes it won't need to tighten further.

Chart #9

There's a silver lining to the housing sector cloud, however. As Chart #9 shows, housing prices are quite high historically, both in real and nominal prices. However, prices look like they have peaked, or at best are only rising modestly. Homeowners familiar with basic math should realize that if home prices fail to rise by a rate that equals or exceeds their cost of money then they will experience a negative return on their housing "investment." Furthermore, borrowing 80% of the price of a house equates to significant leverage (5 to 1), which in turn magnifies any negative return on housing. Viewed from my perspective as a monetarist, this housing "squeeze" is a sure-fire way of supercharging the demand for money (because it depresses the demand for loans), and that in turn should help bring inflation down. Why? Because borrowing money is equivalent to a negative demand for money; thus, the less people want to borrow, the higher their demand for money.

Private sector jobs are still growing

The headline jobs numbers were disappointing on the surface (+29K actual vs +90K expected). But one month's worth of data is not enough to know what the underlying trend is—jobs are notoriously volatile from month to month. I prefer to look at the 6- and 12-month growth rates of private sector jobs; those are the ones that matter. Government jobs have been stagnant for the past six months, and are down 1% over the past year. Flat to down government jobs are actually something to cheer about.

Chart #1

As Chart #1 shows, private sector jobs growth has actually been improving since earlier this year.

However, the rate of improvement is still quite modest, and hardly enough to warrant or justify another Fed rate hike at the next FOMC meeting in late October. 

Jobs growth update: modest improvement in August.

Private sector job growth (the only jobs that really count) exceeded expectations in August (+127K vs +50K), but the overall picture remains the same: jobs growth over the past year or two has been very weak, but it has been improving over the course of the past year. The economy has regained its footing after the illegal-immigrant crackdown and the turmoil induced by Trump's tariffs and the war in Iran. 

To judge by today's reaction to the news, the bond market thinks that today's upside jobs surprise increases the chances of a Fed rate hike at the next FOMC meeting (September 16) from 50% to 60%. I disagree. If anything, I would argue that jobs growth remains so weak that a rate hike might pose a threat to the economy. Recall that two years ago the Fed began a series of six rate cuts which ended last December. That was likely the catalyst that arrested the decline in jobs growth which began in early 2022. Also recall that there is a "long and variable lag" between monetary policy changes and their impact on the economy.  

Nevertheless, jobs growth these days pales in importance compared to the rate of inflation. Expectations for next Friday's CPI report call for little or no change from last month's 3.4% y/y for total, and 2.4% for core—both currently running at only slightly more than Warsh's target. Meanwhile, the housing market continues to suffer from very slow sales growth, weak residential construction, elevated mortgage rates, and flat to falling home prices. These latter factors are likely to act as a continued headwind to the government's CPI calculation, as they have been doing for the past several years.

It's a good thing that Fed Chair Kevin Warsh is hyper-focused on reigning in inflation, but I don't think he will interpret these developments as a reason to raise rates any time soon. 

Chart #1

Chart #1 compares the level of private and public sector jobs. Of note, private sector jobs growth has been tepid in recent years, while public sector jobs—particularly at the federal level—have suffered a significant decline, thanks to Trump’s efforts to trim the federal workforce, which has shrunk by almost 2.7 million on his watch and hasn't been this small since 1966! 

Chart #2

Chart #2 compares the growth rate of private sector jobs, measured on a 6-month annualized and a year over year basis. (Doing this is essential to filter out the notorious “noise” in the monthly data.) It is becoming clear that the economy's vitality reached a low ebb in late 2025 and has since begun to recover.