How bad is fiscal policy?

It's no secret that federal debt is bigger, relative to the economy, than at any time since WW II, that deficits these days are measured in trillions, and that interest on the debt likely exceeds spending on defense. It's unquestionably bad. But is it out of control? Not yet.

To begin with, Federal Debt Owed to the Public is $27.7 trillion. It's not $34.9 trillion, as many will tell you. The latter figure is Total Public Debt Outstanding, but that includes $7.2 trillion of Intergovernmental Holdings. Those holdings are debt that one part of the government owes another (most of it is owed to Social Security). But to include that in the total is double-counting. Social Security surpluses are "invested" in Treasuries, and in this manner Social Security surpluses effectively reduce Treasury's need to sell bonds to finance the larger government deficit. 

Knowing how much the federal government owes to the world is one thing, but the burden of the debt is quite another. The burden of the debt depends on the level of interest rates and the nominal size of the economy. Today the debt is huge relative to the size of the economy, but interest rates are relatively low, with the result that the burden of the debt today is much less than it was in the 1980s, when federal debt was about 40% of GDP, thanks to interest rates today being much lower than they were in the 80s.

Here are some charts that put deficits and debt into perspective.

Chart #1

Chart #1 is a history of federal debt owed to the public from 1970 through July '24. It's plotted on a logarithmic axis, thanks to which a constant rate of growth shows up as a straight line. It's commonly thought that federal debt has been surging at unprecedented rates in the past 5 or so years, but that's not true. Debt grew at a much faster rate in the mid-1980s. For the past 75 years, our national debt has increased on average by about 8.8% per year, and recent years have proved to exception.

Chart #2

Another common misperception about our national debt is that more debt should push interest rates higher, and less debt should allow interest rates to decline. As Chart #2 shows, the relationship is often just the opposite. The peak in bond yields occurred in the early 1980s, when debt relative to GDP was very small and was growing rapidly. In the 2010s, debt was surging relative to GDP and interest rates collapsed. Lots of debt in the 1940s occurred during a period of low and relatively stable interest rates. As a general rule of thumb, interest rates are not determined by the amount of debt, but rather by the level of inflation and the strength of the economy.

Chart #3

Chart #3 shows the source of our national debt—the difference between spending and revenues. Is our deficit the result of it too much spending or not enough revenues? That, like beauty, is in the eye of the beholder. One thing for sure, however, is that the government chronically spends more than it takes in.

Chart #4

Chart #4 helps answer the question from another perspective, by comparing spending and revenues to the size of the economy. The dashed lines on the chart show the post-War averages for each. Since the mid-00s, spending has been much higher than its post-war average, whereas revenues have been generally closer to their long-term average. This suggests that spending is the problem.

Chart #5

Are revenues too low because tax rates are too low these days? Could higher tax rates boost revenues as a percent of GDP? Not necessarily! According to Chart #5, it seems that federal revenues are not at all a function of the level of tax rates. Reagan slashed tax rates in the early 1980s, but tax revenues proceeded to surge relative to the size of the economy in subsequent years—because the economy enjoyed a surge of growth. Isn't it better to achieve a given level of revenues with lower tax rates than with higher tax rates? Taxes distort behavior and weaken the economy. At the same time, government spending tends to be much less efficient than private sector spending. 

Chart #6

What about the source of federal revenues? As Chart #6 shows, the individual income tax generates about half of federal revenues these days. Payroll taxes account for 34%, corporate taxes about 11%, and estate and gift taxes 0.6%. If I could eliminate only one tax, it would without question be the Estate and Gift Tax. Last year it generated only $30 billion, which was about 0.6% of federal revenue. $30 billion is pretty much a rounding error when it comes to government finances. Yet the Estate and Gift Tax has a profound impact on the economy: the ultra rich spend massive amounts of money hiring accountants and lawyers to find a way around paying the tax, and very few pay anything in the end. But small business and family farms are often forced to liquidate in order to pay the tax. And of course it amounts to double-and triple and even quadruple taxation for many, since any money saved and invested must first pay income tax. 

Chart #7

Chart #7 shows the true burden of our federal debt: interest payments on the debt as a percent of GDP. The debt burden was 25-30% higher in the 1980s than it is today. True, the debt burden is likely to continue to climb, especially if interest rates rise. But if they fall, as the Fed has all but conceded they will, then our debt burden should remain within bearable levels for the foreseeable future.

One important thing is missing from almost every discussion of debt and debt burdens: the burden of the debt from the government's perspective is equal to the payouts received by all those who have purchased Treasury securities. One man's debt is another man's asset. Paying interest on our national debt is not like flushing money down the toilet. In fact, the true cost of the debt can only be calculated by considering the benefits the country has obtained by issuing debt. A business can issue tons of debt and still grow, provided it is using the money raised for productive purposes. But governments—especially ours in recent years—are notoriously inefficient in that regard. (As I noted here, our government is spending an enormous amount of money on transfer payments, which for the most part only fund spending, not investment.)

And this leads to another conclusion: the problem with debt and deficits is not the borrowing, it is the spending that created the deficits in the first place. 

Who spends money better: the person who spends his own money, or the person who spends other people's money?

Chart #8

Chart #8 shows the federal budget deficit as a percent of GDP over time. The nominal amounts at key points are highlighted in green text. Note some amazing things: today's deficit is just about as much relative to GDP as was the deficit in 1983, but in nominal terms, today's budget deficit ($1.6 trillion) is 8 times larger than 1983's deficit!

The door is wide open to multiple Fed rate cuts

The evidence supporting multiple Fed rate cuts is now solid. 

As I've been documenting for at least the past year, shelter costs, as calculated according to the BLS's flawed methodology, have been artificially raising reported CPI inflation. Abstracting from shelter costs, the year over year change in the CPI has been less than 2% for 10 of the past 13 months, and in June it was 1.8%. This clearly meets and exceeds the bar that Powell set this week, thus opening the door to multiple Fed rate cuts that could begin as early as the July '24 FOMC meeting, and will almost certainly occur at the September 18th meeting and at subsequent meetings. 

I'm thinking multiple cuts, more than the 2 ½ cuts that are now priced to occur by the end of this year. 

Chart #1

Chart #1 is the one that cements the case for multiple rate cuts. Owners' equivalent rent makes up about one-third of the CPI index, and as the chart shows, this has been adding significantly to the rise in the CPI index until this month. The annualized rate of change in this index for the month of June was 3.37%, which is the lowest rate we have seen April '21. 

Chart #2

I've shown Chart #2 repeatedly for the past year or so. The relationship between the year over year change in Owners Equivalent Rent and the year over year change in housing prices continues: 18-month old housing price changes effectively determine today's shelter costs, according to the BLS methodology. The only good news here is that the deceleration in housing prices which began two years ago dictates that the OER component of the CPI will continue to decelerate at least through October of this year.

Chart #3

Chart #3 compares the year over year change in the CPI to the same change in the CPI ex-shelter. Note that two typically move together, but over the past year there has been a substantial difference between them. That gap, which has persisted for over one year is completely explained by the OER (shelter) component. Absent shelter costs, the year over year change in the CPI has been less than 2% for 10 of the past 13 months, and it fell to 1.8% in June. The overall CPI is very likely to close the gap by moving lower as shelter inflation continues to decline.

Chart #4

Chart #4 compares the year over year change in the CPI ex-energy (which I have chosen mainly because it is a more stable index and thus provides an easier comparison to interest rates) and the level of 5-yr Treasury yields. Treasury yields tend to track inflation but with a lag that can approach one year or so. With the CPI ex-shelter now down to 1.8% (see the green asterisk in the lower right hand corner of the chart), we might reasonable expect Treasury yields to move substantially lower over the next year or so.

In sum, the Fed has no reason to not lower rates soon. The market fully expects the first rate cut to come at the September FOMC meeting, and another 1 ½ cuts to come by year end. I don't see why the Fed can't move sooner and more forcefully. Inflation has been licked, and interest rate sensitive sectors of the economy are really hurting. Lower rates would provide welcome relief, and it would take a whole lot of cuts to add up to any meaningful stimulus. 

Cutting rates now would not be playing politics, since it would not boost the economy by any reasonable measure before the November elections; it would instead be a responsible move to avoid further damage to the economy.

With a little luck we'll survive Biden's departure

This is one of those times when it's easy to find things to worry about, and right now they add up to a big deal. Figuring out what that means for the world of investments is the tough part.

To begin with, for years the federal government has been spending way too much money on non-productive things, thus sapping the economy's inherent strength. The federal debt is now almost 100% of GDP, and debt service costs are rising rapidly. The Fed is most likely too tight, holding short-term interest rates uncomfortably high relative to current and expected inflation. Meanwhile, the economy is growing at a modest pace that is unlikely to pick up anytime soon. Interest-sensitive sectors (particularly housing) are really being squeezed.

But the elephant in the living room is HUGE. The press and the DNC can no longer hide the fact that the president of the United States is mentally and physically unable to perform the duties of his office, and he's getting worse by the day. There is no question that he will not be the Democratic candidate for president on the November ballot (for proof of this, see this editorial in the NY Times). By all rights, and since he is unqualified to run, he is also unqualified to serve. It is thus quite likely that he will depart the Oval Office well before November, since he is now the DNC's worst nightmare. Worst of all, he poses a threat to global peace; nature abhors a vacuum, and the vacuum that pervades the White House is intolerable.

When you consider all this in the context of an equity market that has reached new highs in both nominal and real terms, it is troubling to say the least.

One way to make sense of all this is to conclude that the market is looking across the valley of despair to better times ahead. Biden's vow to allow the Trump tax cuts to expire at the end of next year and to instead raise taxes on the economy's engines of growth is now off the table. Happily, Biden will no longer be able to make foreign policy mistakes (he's been on the wrong side of every foreign policy issue for the past four decades, as Robert Gates once said). The Supreme Court recently issued decisions which will drastically curtail the power of the administrative estate, long Biden's ally, and Trump is likely to do even more in that regard. Green Energy subsidies are now an endangered species, as demand for electrical vehicles crumbles and the nation's power grid struggles to compensate for unreliable wind and solar power generation.

The charts that follow highlight some of the problems the economy is facing, as well as some of the indicators that suggest all is not yet lost.

Charts 1 & 2

Chart 1 shows government transfer payments (e.g., social security, medicare, medicaid, welfare) as a percent of disposable personal income). Since 1970, transfer payments have swelled from 10% of disposable income to now over 20%. Chart 2 shows the percentage of people of working age who are currently working, which began to collapse right around 2008-2009, when transfer payments surged in response to the Great Recession. Transfer payments essentially give money to people who aren't working. To paraphrase Art Laffer, when you pay people who aren't working, don't be surprised to find that fewer people are willing to work. 

Chart #3

It's not surprising, then, that the economy can only muster sub-par growth, as Chart #3 demonstrates. The 3.1% trend growth line (green) began in 1965, only to finally break down in the wake of the Great Recession and its avalanche of transfer payments. 2.2% per year seems now to be the new norm, as the red line illustrates. Had 3.1% prevailed, the economy today would be about 25% bigger. What a difference a 1% annual shortfall in growth can make after 17 years!

Chart #4

Chart #4 is one of my long-time favorites, since it shows two variables that have, until recently, foreshadowed the onset of every recession in my lifetime (with the solitary exception being the Covid black hole). When the Fed raises short-term rates to levels significantly higher than inflation—otherwise known as monetary tightening—and the Treasury yield curve inverts (red line), recessions typically follow. We are now very close to seeing both of these variables manifesting: real rates (blue line) are 3% and rising (still a bit shy of past peaks however), and the yield curve has been inverted for several years. If the economy avoids a recession it will likely be due to the Fed's policy of abundant reserves, an argument I've been making for the past 15 years. Abundant reserves all but guarantee that liquidity remains abundant, and that has the effect of inoculating the economy against credit busts and related recession. I've been making this argument frequently in the past 18 months.

Chart #5

Chart #5 reminds us that interest rates tend to follow inflation, albeit with a lag. (I've chosen ex-energy inflation to illustrate this since energy prices are by far the most volatile of all prices.) Note the asterisk on the lower right-hand side of the chart: inflation ex-shelter prices has been a mere 2.1% for the past year. Given the past behavior of housing prices, headline inflation is very likely to continue trending down. See this post for more information on why this is a valid point to make.

Chart #6

My no-recession-for-now call is not without risk, as Chart #6 suggests. The recently-released Small Business Optimism survey of employment intentions has deteriorated markedly in recent months, approaching levels associated with past recessions. 

Chart #7

Chart #8

Fortunately, financial markets to date show no sign whatsoever of any deterioration in the outlook for corporate profits. That's the message of Charts #7 and #8. Credit spreads on corporate bonds remain quite low.

Although the Fed's tight monetary stance is applying unnecessary pressure to the economy, it has not yet reached critical levels. And given that all signs point to a continuing disinflationary process (see my last post for more details), the Fed essentially has only one choice to make: when and by how much to lower interest rates. They are dragging their feet, but eventually they will figure this out. 

In the meantime, I think we'll need to worry more about external threats to global peace than about the US economy. Unfortunately my crystal ball holds no special insights into the minds of Vladimir Putin and Xi Jinping.

Monetary conditions are returning to normal

On June 25th the Fed released the May '24 data for M2 (the release is scheduled for the fourth Tuesday of each month for the previous month's data). There were no surprises.

The M2 story as I tell it goes like this: Beginning shortly after the economy was put into Covid lockdown by overzealous and panicked officials, Washington flooded the economy with some $6 trillion worth of "stimulus" checks in an attempt to mitigate the pain. The public, having no ability or desire to spend this bonanza in an era of extreme uncertainty, allowed the money to accumulate in their bank accounts, thus swelling the M2 numbers but having little impact on the economy. Then, as the economy began to slowly return to normal beginning in early 2021, the public began to spend their bonanza, having little or no desire to let trillions of dollars sit in bank accounts paying little or no interest. Extra, unwanted money began to inflate prices and fuel a return to economic growth. The Fed was slow to realize this, waiting for almost a year to begin (slowly) raising short-term interest rates in an attempt to entice people to hang onto the money. But the damage was done, with the result that the economy was flooded with almost $5 trillion of extra demand (i.e., about 28% more M2 than usual) that enabled the price level to rise by about 20% or so.

Today the economy is once again functioning normally, growing at about a 2% pace. The excess of M2 has been largely worked off, and what remains of above-target inflation is an artifact produced by estimates of shelter costs that seriously lag reality and are questionable at best (see this post for a more detailed explanation). The M2 wave crested two years ago, and ex-shelter inflation has been 2.1% over the past year, well within the Fed's upper limit of 2.5%.

The big inflation episode is essentially over, but the Fed is once again slow to figure this out, and thus reluctant to lower interest rates. Meanwhile, high interest rates have all but crippled the housing market (30-yr mortgage rates at 7% are prohibitive at a time when wages are failing to keep pace with prices). Commercial real estate prices have tumbled over 20% according to figures compiled by the CoStar Group, and there is lots of talk about a coming wave of bankruptcies. Floating-rate loans taken out at 3% interest rates are resetting sharply higher, to the dismay of borrowers already suffering from stagnant real wages. The dollar is king of the hill these days, thanks to world-beating interest rates, but this is squeezing commodity producers as well as the offshore profits of major industries.

To be sure, not all is bad. The Covid lockdowns led to many unforeseen productivity enhancements (e.g., zoom meetings, remote work). The Fed has been reluctant to tighten, so liquidity conditions remain near-optimal. The return of low inflation has boosted confidence. Corporate profits have not disappointed. Credit spreads are low and relatively stable.

Chart #1

Chart #1 illustrates how the almost $5 trillion of "extra" M2 growth has gradually disappeared. The green line extends the growth rate of M2 from 1995 through 2019). Currently, M2 stands only about 9% above where it might have been without the Covid distortions.

Chart #2

Chart #2 shows currency in circulation, which also experienced a burst of growth but has since returned to its long-term trend growth. Currency is a good proxy for money demand, since people only hold currency if they want to—unwanted currency quickly finds its way back to the bank system to be exchanged for interest-bearing deposits. Money demand surged in 2000-2021, but has since returned to "normal" over the past year.

Chart #3

Chart #3 is another way to measure the demand for money, by dividing M2 by nominal GDP. This is a proxy for the amount of liquidity people are comfortable holding as expressed by a percentage of their annual income. Here too we see things are returning to what might be considered "normal," or pre-Covid levels. 

To sum up, the monetary situation has for the most part returned to normal. This lends strong support to the belief that the Fed has essentially managed to once again tame inflation. Interest rates are quite likely to decline going forward, and the only question is one of timing. Meanwhile, the Fed has lots of "dry powder" to unleash (in the form of lower interest rates) should the economy stumble.

The biggest obstacle the economy faces now is fiscal policy, which will depend to a great deal on the outcome of the November elections. Much as I detest Trump's personality and his affinity for tariffs, I strongly believe his policies (e.g., lower tax rates, reduced regulation, smaller government) would result in a stronger economy than if Biden were granted another term in office.

P.S. Sorry for the dearth of posts this month. We spent a lot of time in Argentina recently, where, among other things, we attended the Cato conference in Buenos Aires. There is still tremendous enthusiasm for Milei and his policy prescriptions, but there are concerns that he may delay dollarization for too long. In the meantime he has accomplished much more than anyone would have thought possible in his first six months in office. 

Tight money hasn't hurt corporate profits

The market tries, but just can't shake its Phillips Curve instincts, which is why any news that is considered to increase the likelihood of interest rates being "higher for longer" is deemed bad for the economy and bad for stocks, and vice versa. It's not surprising that this is so, since decades of experience have taught the market that recessions reliably follow periods of tight monetary policy. ("Tight" being defined, traditionally, as high and rising real interest rates, and a flat to inverted yield curve, and a strong currency. I've maintained for many years, however, that a better definition of tight money would include high and rising credit spreads.)

What the market is missing is that the Fed in 2009 adopted an abundant reserve regime that changed everything. Higher interest rates since then have not equated to bad news for the economy because abundant reserves mean abundant liquidity, and that in turn is what keeps the economy on an even keel and credit spreads low. Meanwhile, falling inflation restores confidence to the economy, and that boosts investment and productivity. That's certainly the case today: credit spreads are quite low—which in turn suggests that markets are functioning well and the outlook for the economy's health is decent. Even though monetary policy is almost certainly tight.

Chart #1

Currency in circulation (Chart #1) grew at a fairly steady pace of 6.6% per year from 2010 through 2019. It then exploded upward in the wake of the massive Covid stimulus spending. Over the past few years the pace of currency growth has slowed dramatically: currency in circulation has increased by only 1.3% over the past year. 

If the trend line in Chart #1 represents "normal," then this chart suggests that money supply (in the form of currency) now matches money demand and monetary conditions are supportive of a low inflation outlook. (As I've argued before, the supply of currency is always equal to the demand for currency, since unwanted currency is simply returned to banks in exchange for deposits.)

Chart #2

The M2 measure of money supply grew at a fairly steady pace of 6% per year from 1995 through 2019, as shown in Chart #2. It then exploded upwards by about $6 trillion, which was the result of the monetization of $6 trillion in COVID "stimulus" checks. For the past two years, M2 growth has been flat to negative. As the chart suggests, it's only marginally higher today than it would have been in the absence of COVID spending. By this measure, monetary conditions have gone from extremely easy to reasonably tight. Tight, because the money supply has shrunk, inflation has fallen, real yields are relatively high, and interest-sensitive sectors of the economy (such as housing) are suffering.

Chart #3

As I define it, "money demand" is best expressed as the ratio of M2 to nominal GDP, which can be thought of as the amount of cash that the average person wants to hold compared to his or her annual income. Chart #3 suggests that, as is the case in the previous two charts, monetary conditions have almost returned to normal. Money demand surged during the Covid crisis, only to reverse once the economy got back on its feet. Money demand now is almost back to pre-Covid levels. There is no longer a huge surplus of unwanted money to fuel rising prices.  

Chart #4

Chart #4 shows the value of the dollar vis a vis a relatively small basket of major currencies and a large basket. Most importantly, the chart adjusts for inflation differentials, which means that it is a good indicator of the purchasing power of the dollar in different countries. By any measure, the dollar today is quite strong from an historical perspective. This is way tight money works: attractive interest rates plus confidence in the Fed's ability to constrain inflation create extra demand for dollars relative to other currencies. 

Chart #5

Chart #5 shows the rate of inflation according to the total and core versions of the Personal Consumption Deflator. Clearly, whatever the Fed has done in the past two years ago has resulted in a significant decline in inflation. 

Chart #6

Chart #6 shows the three major components of the Personal Consumption Deflator. Here we see that prices of durable goods have actually declined in the past year, while the prices of non-durable goods have increased only marginally. The only significant source of inflation is in the services area, which is dominated by wages. It's not unusual for wages to lag price increases in other sectors. Wage increases are thus likely to moderate going forward, and this will bring headline inflation back down to the Fed's target.

Chart #7

Chart #7 shows that corporate credit spreads are very low from an historical perspective. This is the bond market's way of saying that investors are quite confident in the outlook for corporate profits. And, by extension, confident in the future health of the economy. 

Chart #8

I have been updating and publishing Chart #8 for at least the past decade. To this day it amazes me that it has not received more attention. The 3.1% trend line (green) represents the growth path that the economy followed from 1965 through 2007. The 2.2% trend line (red) represents the growth path that largely has prevailed since mid-2009. If the economy had regained the 3.1% growth path after the 2008-2009 Great Recession, it would be fully 25% bigger in real terms today! (What a difference 1% less growth per year can make!) What explains today's slower growth should be the issue that is front and center of the national debate. My short explanation is that the economy has lost its dynamism due to 1) excessive government spending, 2) increased tax and regulatory burdens, and 3) rising transfer payments.

Chart #9

Chart #10

Charts #9 and #10 compare the level of corporate profits to the nominal size of the US economy. By either measure, profits are exceptionally strong. If this is the price of "tight money" then let's have more of it! (Note: I have excluded profits and losses generated by the Federal Reserve's abundant reserve regime from overall corporate profits.)

Chart #11

A traditional measure of equity valuation on a macro level compares the price of stocks to the trailing 12-month sum of after-tax corporate profits (the price-earnings ratio, or PE). Chart #11 does the same, but it uses the level of after-tax corporate profits as calculated by the National Income and Products Accounts over the past quarter. This is a more timely and more consistently-calculated measure of profits than the traditional PE ratio. (I credit Art Laffer for this, an approach he has been using for over 40 years.) By this measure stocks are relatively expensive, but not extremely so. 

Chart #12

Borrowing from Art Laffer again, Chart #11 compares the theoretical level of corporate profits (calculated as the capitalized value of NIPA profits—profits divided by the 10-yr Treasury yield) to the market value of stocks as proxied by the S&P 500. Note that, according to Chart #12, stocks were hugely "overvalued" in 2000, and they were also very overvalued at that time according to Chart #11. Today, however, stocks appear to be appropriately valued, since their actual and nominal valuations are roughly equal. 10-yr Treasury yields both drive and explain the differences between these two measures of equity valuation.

This in turn implies that lower interest rates (which should follow the decline in inflation) will increase the appeal of equities as an asset class. This in a nutshell is the "Fed put" that I mentioned in my previous post. Tight money hasn't hurt the economy at all.

Charts with a message

The US economy grew 3.1% last year, trouncing widespread calls for a recession and exceeding my relatively sober expectation for 2% growth. With growth apparently persisting this year, and with popular inflation numbers marginally higher than the Fed's target, both the market and the Fed now question whether and by how much the Fed should cut rates. The prevailing market wisdom holds that the Fed will cut rates once before year end; they might move sooner, however, if the economy shows clear signs of slowing down and year over year inflation falls below 2%.

I continue to argue that the Fed has essentially reached its inflation target. M2 money growth has been flat to negative for two years, and inflation ex-shelter costs (which are artificially inflated due to the BLS's faulty measurement) has declined to the Fed's target. Moreover, today's interest rates are high enough to almost paralyze the housing market, high enough to keep the dollar strong, and that in turn is enough to depress most commodity prices. Fortunately, credit spreads are still quite low, and, when combined with plentiful liquidity, it's not hard to conclude that monetary policy is not tight enough to precipitate a recession.

The correct way to view the interplay between growth and inflation is to first understand that high inflation is bad for growth, while low and stable inflation is conducive to growth. Economic growth by itself does not cause inflation—only monetary policy does. As my mentor John Rutledge explains it, inflation is like fog on the highway; it forces everyone to slow down because of a lack of visibility. Inflation creates uncertainty about the future value of the dollar, the level of interest rates, and prices. Reducing inflation thus eliminates uncertainty and promotes investment, which in turn drives growth. In short, the economy grew so much last year because inflation fell. 

The charts which follow have several messages: 1) interest rates are high enough to cause some serious problems in the housing market, while at the same time boosting the dollar and keeping downward pressure on commodity prices, and 2) some sectors of the economy—manufacturing, international trade, small businesses, commercial real estate, and the service sector in general—are struggling even as the high tech sector continues to boom and corporate profits are showing healthy growth (which is why the stock market is moving higher).

Chart #1

The average rate on mortgages held by the public is 3.9% or so, whereas the current mortgage rate for new 30-yr loans is 7.2%. This creates a powerful incentive to avoid selling one's home, because acquiring a new mortgage is extremely expensive. It also depresses the demand for housing because 7.2% mortgage rates make home prices quite unaffordable for the vast majority of people. Housing supply and demand are both very constrained, with the result that the market is not likely in an equilibrium situation. Conditions could change dramatically at any time.

Chart #1 also shows that the spread between mortgage rates today and 10-yr Treasuries (the backbone of the mortgage market) is elevated. Why? Because investors are reluctant to buy 30-yr mortgages that could turn into very short-term interest rate loans should Treasury yields decline (because those who borrow at today's high rates would rush to refinance if rates fell). In sum, homeowners don't want to sell, buyers don't want to buy, and lenders (investors) don't want to lend. Again, this is not a healthy market and these conditions cannot persist much longer. 

Chart #2

As Chart #2 shows, housing hasn't been so unaffordable for many decades. 

Chart #3

Chart #3 shows that the volume of new mortgage applications is at very low levels, having dropped by roughly 75% since the heydays of 2005-2006. 

Chart #4

As Chart #4 shows, and as is consistent with the big decline in new mortgage applications, the volume of home sales is very low from an historical perspective. 

Chart #5

As Chart #5 shows, housing starts are weak because builders are not confident that the outlook for the housing market is healthy. Modest growth in home construction will not be a source of stronger overall growth. What is clear is that the housing market needs a significant decline in interest rates in order to improve.

Chart #6

As Chart #6 shows, industrial production in the US has been flat for several years. Meanwhile, industrial production in the Eurozone is suffering from recessionary conditions. The US economy is the global economy's primary engine of growth these days, but it is not very impressive.

Chart #7

World trade volume (Chart #7) surged from 2000 through 2019, but has since stagnated. Geopolitical tensions undoubtedly explain most of this, but without an increased pace of trade the global economy is lacking a key engine of growth. Heaven help us if war spreads to Europe and throughout the Middle East. 

Chart #8

As Chart #8 shows, small business optimism is very low. Small businesses are essential to the overall health of the economy, so this is a troublesome sign. Likely culprits: increasing regulatory burdens, high inflation, high tax burdens, green energy subsidies which incentivize unproductive investment, geopolitical tensions, and the political polarization which increasing divides the economy.

Chart #9

Chart #9 shows that commodity prices have a strong tendency to move inversely to the strength of the dollar. (The dollar is plotted on an inverse y-axis, so a falling blue line means a stronger dollar.) What stands out here is that commodity prices are unusually strong relative to the dollar. But their ability to rise appears to be constrained given the dollar's ongoing strength. 

Chart #10

Chart #10 tells us that the dollar's strength owes a lot to the fact that US interest rates are much higher than those in Europe and the rest of the developed world (the blue line represents the spread between 2-yr US and German yields). Stronger US growth and more attractive yields combine to enhance the appeal of the dollar vis a vis other currencies. This is turn helps depress commodity prices, which also helps to restrain inflation. 

Chart #11

Chart #11 tells us that the commercial real estate market is facing serious problems. On a value-weighted basis, commercial property prices have fallen 20% from their July '22 high. By the same measure, office property prices (not broken out here) have fallen 34.5% from their all-time high.

Chart #12

Chart #13

Chart #12 suggests that business activity in the service sector of the economy (by far the largest sector) has fallen significantly of late. Chart #13 shows that that less than half of service sector businesses plan to increase the number of jobs. By this measure, the service sector could be experiencing recessionary conditions. It also reinforces the message of Chart #8 (small business optimism), and together the two tell a troubling story.

Chart #14

Chart #14 shows the year over year change in the number of private sector jobs according to the establishment survey. (Private sector jobs are the only ones that really count, in my opinion.) Jobs are growing at a relatively moderate 1.7% annual pace, which is nothing to get excited about. If this were to continue, it would probably be enough to sustain an overall pace of growth for the economy of about 2.5% - 3.0% per year—which is at odds with all the charts above that tell of weakness. What stands out here is the rather significant deceleration of jobs growth since the beginning of 2022. This is not a boom, but neither is it a bust. Yet.

Chart #15

Chart #16

Chart #15 is an updated version of a chart I have been featuring for months. What it says is that if it weren't for the way the BLS computes housing prices (which is based on the year over year change in housing prices 18 months ago), inflation today would be within the Fed's target range today. (The Fed is targeting 2% inflation in the Core Personal Consumption Deflator, which is equivalent to about 2.5% in the CPI, because the CPI tends to exceed the deflator by roughly 0.5% per year.)

Chart #16 all but proves that the BLS uses ancient housing prices to compute today's rate of shelter inflation. The red line has been falling almost exactly in line with the yoy change in housing prices 18 months ago. If this relationship holds, then the red line will fall from 5.8% today to about 2.5% by October, and this would in turn subtract a significant amount of shelter inflation from the overall CPI. 

On balance, I see the risks pointing to weaker rather than stronger growth, and lower rather than higher inflation. If the economy weakens, interest rates are quite likely to fall, and that will reduce the threat of further weakness. I think the stock market sees this as well, in the form of what is called a "Fed put," or what is akin to a hedge against recession.