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

revise?????

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.

Still no boom, no bust

Back in July I ran a post titled "No boom, no bust." Things haven't changed much since then: inflation has come back down to earth, and the economy continues to grow, albeit slowly. Stocks are up a bit, the Fed tightened once, credit spreads have tightened a bit, and the market continues to worry that another Fed tightening might be the kiss of death for the economy. 

Chart #1

Chart #1 compares the level of the S&P 500 to the level of the Vix "fear" index. The two tend to move in opposite directions: rising fear levels result in lower stock prices, and vice versa. The Vix index is back down to pre-Covid levels, and stocks have been rising—though not yet to new highs. 

Chart #2

Chart #2 shows Bloomberg's Financial Conditions Index, a reliable measure of the underlying health of the financial markets and thus a forward-looking indicator of the health of the economy. Conditions are about average these days, so it's reasonable to expect the economy will continue to grow, albeit slowly (~2%). 

Chart #3

Chart #3 compares industrial production levels in the U.S. and the Eurozone. There has been very little progress in the level of industrial production since 2007, although the U.S. economy has been somewhat more dynamic than the Eurozone economy by this measure. Still, nobody's posting gangbuster numbers.

Chart #4

Chart #4 shows U.S. manufacturing production, a subset of overall industrial production. Here again we see very little improvement in recent decades. Ho-hum. But neither do we see any deterioration.

Chart #5

Chart #5 shows two measures of producer price inflation at the final demand level. This captures inflation at an earlier stage of inflation pipeline than the CPI. By either measure, inflation has fallen to less than 2%. The Fed's done. The CPI won't be far behind, except for the fact that energy prices have spiked of late—through no fault of the Fed's. Biden's Green agenda is at work here, as well as fallout from the Ukraine-Russia war.

Chart #6

Chart #6 shows two broader measures of inflation at the wholesale level (as of August). Here again we see inflation back down to where it should be: 2% or less. 

Chart #7

Chart #7 shows the 6-month annualized rate of change of the CPI compared to the CPI less shelter costs. As I and many others have been pointing out for the past several months, shelter costs have been artificially inflated as a result of the BLS using backward-looking statistics related to housing prices. 

Chart #8

Chart #9

The major component of shelter costs used in the CPI comes from what is called Owner's Equivalent Rent. As Chart #9 shows, OER is driven primarily by housing prices 18 months in the past. The chart shifts OER to the left by 18 months to correct for this. Here we see the peak in housing price inflation corresponding to the peak in OER. Since housing prices peaked over a year ago, OER is now beginning to decelerate. That deceleration is showing up very clearly in Chart #8, which looks at changes in the level of OER over 1- and 3-month annualized rates. What this means is the OER is going be contributing meaningfully to lower rates of CPI inflation in coming months. 

The FOMC meets next week, and I see no reason for them to raise rates yet again. The big question is when they will begin to lower rates. Today the market is betting on a 30% chance of another rate hike at the November meeting, with rate cuts not likely until mid-2024.

It's important to note (again) that Fed tightening this time around is fundamentally different from tightening cycles in the past. The main difference this time is that the Fed is not draining reserves from the banking system. Reserves are still plentiful at over $3 trillion. That's a huge deal. Chart #2 makes the point another way: there is no shortage of liquidity in the financial markets, unlike during periods leading up to recessions in the past. The only thing that is "disturbing" the economy this time around is that short-term interest rates are relatively high. That doesn't necessarily pose a threat to the economy. It simply makes it more attractive for people to hold money—that is, higher rates increase the public's demand for money, and that in turn neutralizes the amount of "excess" M2 that is still circulating. See this post from late August for a more detailed explanation.

Is this a great country or what?

The list of things that could be better in this country is long and distressing. But the good news is that economic conditions in the U.S. continue to improve, despite all the bad news.

Here are some charts that make the point:

Chart #1

Chart #1 shows the condition of U.S. households' balance sheet. Private sector net worth now stands at a record $154.3 trillion, almost double what it was just 10 years ago. 

Chart #2

Chart #2 shows the inflation-adjusted net worth of U.S. households. It's been increasing on average about 3.6% per year since 1952. That works out to a 12-fold increase in just 70 years. 

Chart #3

But, you say, the population has also increased a lot over that same period. So Chart #3 adjusts the data for Chart #2 by population, which has roughly doubled since 1950. Here also we see steady and impressive growth in inflation- and population-adjusted private sector wealth. By that measure, and as a rough approximation, the living standards of the average American have increased by a factor of almost 6 in the past 73 years. 

Chart #4

It's outrageous that our federal debt as a percentage of GDP is almost 100%. It was about 60% in the early 1950s, then it fell to a low of about 25% in the mid-1970s, and since 2007 it has increased from just over 30% in 2001 to 95% now. Fortunately, the private sector has de-leveraged significantly—by about 40%—since 2007, as Chart #4 shows. It's now back down to where it was in the early 1970s.