Interest Rates, Housing and Inflation
A lot of numbers came out this week which put a spotlight on interest rates, housing and inflation. All of these areas link together. An excerpt and paraphrase from New Republic Capital Markets views follows along with informaiton from Asia Times. We added commentary in places to clarify, but included links to original information.
Larry Summers (Treasury Secretary under Bill Clinton) may have preferred not to have seen the inflation numbers from January 12 and January 13, 2022. But he might just have felt a flicker of satisfaction at further confirmation that he has been on the right track about rising prices. Under the circumstances, it’s worth scrolling back a few days and seeing what Summers was quoted by Bloomberg the week before the inflation numbers were released. He said that even after the Federal Reserve’s recent hawkish pivot and after a selloff in Treasuries, both policy makers and investors are still underestimating what will be required to bring down inflation.
“My own view is that the Fed and the markets are still not recognizing what’s likely to be necessary,” Summers said on Bloomberg Television’s “Wall Street Week” with David Westin. “The market judgment and Fed’s judgment is that you can somehow contain this inflation without rates ever rising above 2.5% in terms of the fed funds rate.” . . .
Summers Outlook
Summers, a Harvard University professor . . . said that if inflation did come down without the Fed hiking its target rate past 2.5%, that would only be likely if the U.S. economy had proved unable to cope with tightening of a lesser scale.
“What we’re going to find out is what the vulnerability of the economy is to rate increases,” Summers said. “It may be, as some argue, that because of greater levels of debt, because asset prices are substantially inflated, the economy is more vulnerable than usual to rate increases or to quantitative tightening.”
Focus on that last sentence. Firstly, it raises the question of whether the Fed has the stomach to increase rates (or expectations of where they will go) enough. A level necessary may lead to a possible crash. That level may not be much higher than current expectations as recent movement in tech stocks shows. Would that extend beyond the financial markets into housing market and other assets? An underlying housing shortage may provide some sort of floor.
Edward Price in the Financial Times:
Lurking ahead is the hobgoblin of financial crises. Central banks cannot reconcile tightening, to serve the needs of the economy, with ongoing accommodation, for wider financial stability. Super low rates risk financial bubbles and eventual turmoil. But super high rates risk popping those bubbles in calamitous ways. After years of quantitative easing, the incongruity between the monetary needs of the economy and the monetary needs of markets is inescapable.
Is the Fed prepared to risk (or tough out) a crash?
Then there is the question of what rate hikes might mean for the indebted. Summers may be talking about private- and public-sector debt — and reasonably so. Given the level of debt that the U.S. has now incurred, that focus on public finances may be warranted due to constraints on the Fed’s willingness to increase rates. In that connection (and taking a longer view), it’s worth taking a look another view. Brian Riedl’s excellent, but less than cheery, paper for the Manhattan Institute addresses the intersection between interest rates and federal debt here.
History and Other Views
As a reminder, the latest inflation levels are the highest since 1982. At that time Paul Volcker’s squeeze was already being reflected in the numbers. Inflation was falling but recall that the cure involved the Fed Funds rate peaking three times at 20 percent. That’s would be disaster today.
John Cochrane, writing in September (excerpted and paraphrased):
Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when the Fed started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly. Overspending set new records every year recently., with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point. At 100% debt-to-GDP, 1% of GDP is around $227 billion.
There seems to be little doubt that the Fed now realizes that it has left things . . . a little late.
The Financial Times (excerpted, paraphrased):
The [inflation] data, which were released come just a day after the Fed warned high inflation was a “severe threat.” That threat is to the labor market, the second mandate of the Fed. The first is price stability (oops).
“The Fed is now behind, so the urgency you hear in Powell’s voice on inflation is him playing catch-up,” said Tom Porcelli, chief US economist at RBC Capital Markets. “The justification for the Fed to respond to inflation happened months ago.”
Summers believes that inflation is unlikely to come down to where the Fed would like it without Fed Fund rates above 2.5%. But the level of government debt may vex the Fed as to how high to raise interest rates. In real and historical terms, 2.5 percent is anything but high.
Claire Jones at the FT:
The federal funds rate is now about eight percentage points lower than it was the last time inflation was north of 6 per cent.
While (many) would not be surprised to see a somewhat sharper slowdown than others expect, the recession risk is unknown.. The Fed will increase rates, but not in a way that suggests that they are going above 2.5 percent. Additionally, some of the elements contributing to the current inflationary may fade. Supply-chain disruptions and labor shortages may moderate or lessen, but no end is in sight in the near term. Perhaps by mid to late-2022 there may be an easing in inflation. Or maybe not. An easing may mean the price increases slow, not stop. Unless demand is crushed. Put these two factors together, and we can expect to have to live with higher levels of inflation for longer than Washington would like us to believe. Energy costs and “shelter” (housing and its derivatives) could well be significant contributors.
Is all this a prelude to stagflation? Perhaps not unless those set on greenflationary policies have their way. A serious move to the embrace “green” policies like the Green New Deal or “Zero Emissions” would likely bankrupt all involved. Interest rates, housing and inflation go hand in hand. Read Winning Mortgage, Winning Home to prepare for good or bad conditions. And for opportunities.
Understated Inflation
How much has the Bureau of Labor Statistic (BLS) measures understated inflation? Shelter accounts for about a third of American household expenditure. The cost of buying or renting shelter is up nearly 20% over the past year. Yet the Consumer Price Index (CPI) for shelter reported Jan. 12 by the BLS showed an increase of just 4.2%.
Private surveys conducted by the big rental sites, Zillow and Apartmentlist.com, show increases of 13% to 18% during 2021. Case-Shiller Index of US home prices jumped 18% in the year through October.
Who are you going to believe, to paraphrase Groucho Marx – the BLS or your own eyes?
Measuring Shelter Costs
Part of the discrepancy involves a simple time lag. The BLS looks at the present cost of housing while the private rental surveys register the cost of a new rental. It takes a while for leases to expire and new, higher-cost leases to take effect.
Changes in the Apartmentlist.com rent index predict changes in the CPI shelter index with lags up to eight months. That explains at least part of the divergence of the CPI rent inflation number from the private rental surveys.
This time, the CPI rent inflation rate of 4.2% undershot the private rental data. As old leases expire and new leases are written, the CPI index for shelter should rise by 14 percentage points. Shelter makes up 32.3% of the CPI, so 14 percentage points in the cost of shelter would add another 4.5 percentage points to the headline inflation number.
That’s an additional 4.5 percentage points on top of the 7% annual rate of CPI inflation. In other words, accurate accounting for real-world shelter costs would put consumer inflation in the US around 10% a year. And double-digit inflation would cause a market meltdown.
There’s no sign of relief in cost pressures on business. Transport costs have been rising at an annual rate of 30% to 50% for most of the past year.
Other Inflation Pressure
Average hourly earnings rose 4.7% year-on-year, the highest since the series began in 2007. With inflation at 7% (as we just saw, even higher) that represents a 2.3% annualized pay cut, so workers are demanding more pay.
The probability is that inflation will run closer to 10% than 5% for the first half of 2022, pushing the Fed to tighten more than investors now expect. Understated inflation now is a risk for the future. The past is the past, it’s the future which may impact interest rates, housing and inflation as well as your wallet in 2022 through 2025.