Thursday, September 21, 2023

What the Fed is overlooking

Yesterday the FOMC decided to keep its target Fed funds rate unchanged at 5.5%. That was no surprise to the market, but the tone of Powell's press conference and meeting minutes convinced the market that rates are likely to be "higher for longer" than previously expected. Market expectations are now geared to expect one more hike before year end, and only a few cuts by the end of next year. To judge by the market's reaction, there's a bit of panic in the air—maybe this time the much-feared recession that was just around the corner most of the year will finally arrive?

It's a shame that economic growth has come to be feared rather than welcomed. We've had 2% growth for over a year now, and inflation has plunged. Growth doesn't cause inflation; too much money relative to the demand for it is what does. The Fed was late to the tightening party, but they have delivered in spades. Today's high interest rates have boosted the demand for money by enough to result in a significant decline in inflation. 

It's terribly unfortunate, but the Fed worries that they haven't done enough, and that they may have underestimated the economy's strength. This tells me that the Fed is overlooking some very important developments: 1) the fact that inflation by current measures has already fallen within range of its long-term target (see Chart #7 in this post), 2) the ongoing slowdown in the growth of private sector jobs, and 3) the emerging weakness in the housing market. 

This post focuses on the housing market, which has suffered a triple whammy of soaring home prices, soaring mortgage rates, and soaring spreads over Treasuries that has combined to crush new mortgage applications, weaken housing starts and cool builder sentiment. 

Chart #1
Chart #1 shows the nominal and real (inflation-adjusted) index of national home prices according to Case-Shiller. (Note: the June figure is actually an average of April, May, and June prices). Home prices are within inches of their all-time highs, and 15% higher, in inflation-adjusted terms, than they were at the peak of the housing market boom in 2006. 

Chart #2

Chart #2 shows the level of 30-yr fixed rate mortgages (blue), the level of 10-yr Treasury yields (red), plus the spread between the two (green). As is widely known, 10-yr Treasuries set the bar for fixed rate mortgages. In normal times, mortgage rates tend to be about 150-175 basis points higher than Treasury yields. Today, however, they are about twice as high as that (320 bps). Treasury yields have surged from 1.5% in early 2022 to now 4.4%, and mortgage rates have exploded from 3% to now 7.25%. Since the effective rate today on all outstanding mortgages is about 3.7%, anyone refinancing or taking out a new mortgage faces the prospect of a huge increase in mortgage payments on top of housing prices that have climbed to record levels. It's enough to make nearly everyone think twice. And what they're thinking is that borrowing money today is not a pleasant experience. That is how higher interest rates increase the demand for money: it's better these days to be long money than short money—in the sense that being "long" means you own it, while being "short" means you owe it. What a change from a few years ago, when I noted repeatedly that the Fed was encouraging people to "borrow and buy."

Chart #3

Chart #3 shows an index of new mortgage applications, which are down 70% from the highs of the mid-2000s, and down over 50% from the highs of late 2020. Housing market activity has been severely impacted by higher rates, and the Fed's stance today promises no relief for the foreseeable future. This is powerful evidence of an increase in money demand.

Chart #4

Chart #4 shows a measure of housing affordability, which today is as low as it has ever been, thanks to the combination of soaring home prices and soaring mortgage rates. (I would guess that the affordability of homes in the Los Angeles area would register about 60 on this chart.) 

Chart #5

As Chart #5 shows, since early last year existing home sales activity has dropped by 36%, to levels not seen since the depths of the housing market slump in 2010. Very few want to sell, and very few are able to buy. This is evidence that the housing market is unstable. Very low turnover means that prices are not a reliable indicator of value.

Chart #6

Chart #6 compares housing starts to an index of homebuilder sentiment. Both have dropped sharply from the highs of the past few years. Since early last year, housing starts have fallen almost 30%, and homebuilder sentiment has dropped by almost 50%. Over the same period residential construction spending has dropped about 10%—with further drops very likely to come in the months ahead (residential construction spending is highly correlated to housing starts, but with a lag). 

All of this is reason enough to question the overall strength of the economy. Lurking in the background are $2 trillion annual deficits fueled by excessive and wasteful government spending, the Biden administration's recent throttling of oil exploration and drilling activity, and soaring energy prices. Very expensive energy, just like high taxes, are sure-fire ways of throttling economic growth. Too much government spending is almost guaranteed to sap the economy's strength.

Conclusion: The Fed is highly unlikely to deliver on its "higher for longer" interest rate target for much longer. In coming months events are likely to transpire which will convince both the Fed and the market that inflation is lower and the economy is weaker than commonly thought. And that interest rates need to come down.


wkevinw said...

Agree that real estate market is not "stable"/dysfunctional. All over the (developed economy) world, residential real estate is priced too high for proper economic and social function.

The whole idea that people don't need to own anything is at work. If you want a dysfunctional society, try that. You will have low fertility, high social dysfunction (e.g. crime, substance abuse) and other maladies.

If you want a stable social and economic system, let citizens own things like their own home. They will then be productive, etc.

Real estate prices need to come down. If that means higher rates for longer (until prices trend down), that medicine should be taken.

Thanks for the post.

Salmo Trutta said...

re: "If that means higher rates for longer"

Rates will be higher without QE. For housing prices to come down, the FED would have to drain reserves for a considerable period (like Greenspan did when he caused "Black Monday").

wkevinw said...

In ~1980, it seems like it was a requirement to have 20% down payment, a good loan to income ratio, and other fairly steep metrics, in order to get a "typical" home mortgage.

If the federal agencies who handle (eventually own?) mortgages moved requirements to this level, I think the "ability to pay" part of the demand equation would be such that real estate prices would come down- even with rates that weren't that high.

That would have other consequences, of course.

Salmo Trutta said...

The FED is really screwed up. Their accounting has become worse over the decades. Savings are only invested if there's a turnover of money, an exchange in the ownership.

The conventional wisdom is that the banks lend deposits. But bank deposits have a zero payment's velocity, as banks always create new money whenever they lend/invest with the nonbank public. It's just too hard to fathom that savings are not synonymous with the money supply.

RR said...

Hi Scott,

Your posts are insightful and provides excellent outlook to the individual. I am follower of your thoughts and rationale, and really appreciate the your efforts to disseminate the knowledge.

Referring to your latest post, You mentioned that "Since the effective rate today on all outstanding mortgages is about 3.7%". Quoting the same, You meant that Average rate on outstanding mortgage amount is 3.7 % (after resetting for the peak interest rate of 5.5 %).


You meant that effective mortgage rate on outstanding mortgage (Nominal Mortgage rate - Inflation) is 3.7% ?

Scott Grannis said...

RR: I’m referring to the average rate owed by all those who have mortgages. Not the real rate.

RR said...

Scott, Thanks for your response.

Matt from Cleveland said...

Scott, Are you familiar with the “convexity” of bond prices which cause those prices to rise by double digits as interest rates decline.

Scott Grannis said...

Matt: I spent most of my professional career working at a fixed income outfit (Western Asset), so yes, I am quite familiar with duration and convexity.

Roy said...

Yields still going up. With every day passing the Fed is engineering a hard landing/recession.

Tom L said...

Not sure why Brian Wesbury keeps with his thinking that "a recession is highly likely". He made that call and has not turned back.

Roy said...

Rates go up -> more BTFP -> higher liquidity -> tech/bio goes up.

Seems like a reasonable actionable plan.

Duncan said...

Tariffs, public sector unions, industrial policy supply restrictions, entitlements linked to inflation, environmental policy, presentient effects of covid supply chain policy, subsidies, Farm Bill, our legislative and executive branch are like an inflation making machines. True these have always been around, but at the margin they are making supply more difficult and costs higher. SG explains money demand which will be working in other direction given higher rates, but which will prevail. Even a recession will not reverse bad policy decisions. One hopes the private sector and productivity will bail us out again.

Vandy said...


Wesbury put his line in the sand predicting we’d be in a recession by now more than a year ago. Jamie Dimon predicted it too, as did most ‘experts’.

Duncan said...

Bank executives and such always appear wise and prudent when they predict a downturn that does not occur, "prepare for the worst, but hope for the best" type of thing. It costs them very little when they are wrong. They make their money on fee's, commissions and rate spreads not taking directional bets.

Dan said...

Well at least the Fed have some "bullets" now when the next recession comes.

Roy said...

It was mentioned on twitter that spreads in mid 07 were quite close to today's. Reading this blog it seems that spreads are not indicating a coming recession, and yet they also didn't in 07 ... So, how to look at it? Thanks.