We are currently living through one of the most intricate macroeconomic environments ever. When even the experts are unaware of what comes next, and what is the best approach to overcome this inflationary environment.
The recent Fed hike of 75 basis points shows the determination of the central bank to curb or control inflation. If we compare historically, we see that in past inflationary periods interest rates had to be above the CPI, in order to meaningfully reduce inflation.
What this leads us to conclude is that the goal of the Fed is to maintain inflation within a controlled range, thus revealing their concern that an excessive rate hike could potentially cause an enduring recession with far worse consequences.
Additionally, the Fed is also looking at other indicators such as the PCE (Personal Consumption Expenditures), which not only shows the effect of inflation but also conveyed changes in consumer behavior.
How interest rates affect inflation and the housing market
Interest rates are nothing more than the cost of capital, they directly influence how an economy performs. If the cost of borrowing is higher, then consumers will avoid credit, and as interest rates rise, so do personal savings as the returns generated by bonds, treasuries, or CDs increase. However, rate increases also have an impact on borrowers and even financial institutions. There are typically two types of loans – fixed or variable rates. Borrowers who choose a variable rate are affected by interest rate increases, which end up costing them more to repay their debt since the interest-bearing debt is higher. This also affects lenders, who might be more restricted to lending capital, and some borrowers might even become delinquent, which leads to defaults.
We have started to see this trend in the housing market, with several experts predicting a decline of 5% over the coming year.
The lower housing prices are just a reflection of the higher cost of borrowing and the increased mortgage rates as the 30-year fixed rate approaches 6%. This is starting to be reflected in the mortgage applications numbers which hit a 22-year-old low. Similar to what happened to the stock market this year, the housing market could face a correction over the coming year.
Will inflation persist?
In the midst of this scenario, it is important to determine whether or not inflation will persist. Although the Fed seems determined to control inflation, there are several signs that it could persist for years to come.
Shelter inflation seems to be lagging, and so the higher rent prices should be reflected in the CPI over the coming months. The current increase in rent is also pricing some Americans out of a home entirely. Additionally, some supply chain bottlenecks are still unresolved, specifically when it comes to energy commodities.
Europe is facing one of the most challenging winters, and we might even witness widespread blackouts in Germany. This puts additional pressure on natural gas prices, which have hit the highest level since 2008.
Despite the slight decline over the last month, oil prices are still elevated, and the supply is terribly constrained which should continue to put additional pressure on the expenses of families.
Despite the inflationary pressures, unemployment has remained low at 3.6%. Despite this, several companies are having a hard time finding workers, and this creates additional inflationary pressure in the form of wage inflation.
On top of this, there is certainly political uncertainty surrounding the current administration. Biden’s approval rating is at its lowest.
Democrats have also shown their discontentment with the president, with 75% of Democratic voters assuming they want someone else leading the country.
With the upcoming midterms, we are looking at potential political instability that could continue over the next 2 years.
Recession indicators have also sounded the alarm on a possible recession over the coming year.
The Shiller P/E which measures the price of stocks relative to their earnings in the past 10 years, is still at elevated levels despite the decline of the major indexes this year.
The Buffett recession indicator, which is nothing more than a ratio between the total stock market value and the GDP, is still high.
Finally, the yield curve which has predicted most of the past recessions compares the interest on treasuries with their maturities. Typically, the longer the maturity on a treasury, the higher the interest paid, but when investors sense there is a recession on the horizon they bid up usually the 5 to 10 year treasury, which ends up having a lower interest than shorter term treasuries. The yield curve couldn’t be more inverted, which shows that investors are skeptical of the outlook for the coming years.
Can the Fed lower rates?
While it has been argued that the Fed could pivot, and take a dovish stance in 2023 to avoid a recession, there is still a lot that can happen. Given the unprecedented macroeconomic environment, even some of the most respected experts are unsure what exactly will happen.
For instance, Jamie Dimon has warned the public of a hurricane coming, and that are currently big storm clouds that could dissipate or not.
It also seems like the current administration is looking closely at the situation, and despite the publicized independence of central banks, it is clear with the previous and the current administration that the White House is closely following each of the Fed’s decision. As it can have a direct impact on their political influence and the general public’s perception.
A new economic reality
It seems fair at this point to conclude that the macroeconomic experiment we have all been living dubbed MMT ( Modern Monetary Policy) does not work as it is supposed to. On paper it looks great, deficits don’t matter and all it takes to revive the economy is to cut rates and inject liquidity into the system but its all a myth. What we have come to learn is that these decisions, have unwanted consequences, namely inflation.
While we may debate the technical definition of a recession being two consecutive quarters of negative GDP growth, the fact is that despite some positive macroeconomic indicators coming from the labor market, there is a threat of a serious downturn.
The Fed currently has a treacherous way ahead. While it may want to increase interest rates, to end inflation once and for all, it might not be able to do so. It would cause a recession, that could put the US at risk of default.
To understand the depth of the situation we are in we have to go back to the great ifnancial crisis of 2008. During the great financial crisis of 2008, governments all around the world took on debt in order to bail out the private sector.
This time around, the level of debt is so astronomically higher that most governments are unable to have the same intervention they did in 2008 without causing undesired effects, such as prolonged inflation, or even risking defaulting on their sovereign debt.
Pushing rates too high, would decrease consumption, and it would certainly affect tax revenue. On the other hand, the interest on treasuries would also increase significantly. Putting the country in a situation where it might default, or where the Fed needs to keep buying treasuries in order to keep the debt markets operating.
The Fed currently owns ~23% of the national debt, and while foreign investors continue to buy US treasuries, their ownership relative to the total debt is declining.
Another question comes to mind amidst all this:
How is the Fed supposed to unwind its massive balance sheet that is close to $9 trillion with higher rates?
There is no clear answer to this question, and despite the Fed’s plan to shrink its balance sheet, it needs certain conditions to meet this objective. This is why an interest rate hike induced recession could threaten the US ability to issue treasuries, and it would put additional pressure on the Fed to acquire treasuries, while trying to shrink its balance sheet.
Can the Fed raise rates?
What most people do not seem to realize is the deep-rooted effect created by nearly a decade of near-zero interest rates had on how the economy operates. Additionally, the Fed has previously tried to take a hawkish stance, namely in 2018, which culminated with a total pivot. If the Fed was unable to raise rates during 2019, which had planned to do, what makes some experts think that it can do it now when the conditions are much worse.
The bottom line
The elephant in the room is the fact that governments around the world need inflation, to decrease their sovereign debts not in nominal terms but in a percentage relative to their tax income.
This is why there will be no significant attempt at reducing inflation in the near term, and all the Fed and other central banks will try to do is to control inflation within a certain range, at the expense of retirees, savers, and lower income families. Raising rates too high could cause a global recession.
There is no Paul Volcker this time around, to save us from ourselves. And even if Paul Volcker himself was the Fed chair, he would certainly be unable to have the same approach he had over 40 years ago.
The conditions are simply not the same, and the world today is far more dependent on global trade, and each central bank decisions has repercussions worldwide. The current conditions warrant caution, in one of the most unpredictable macroeconomic scenarios we will ever experience.