Thoughts of the Week
Eugenio J. Aleman, PhD, Chief Economist
Giampiero Fuentes, CFP, Economist
Over history, it has not been easy for markets to understand the Federal Reserve (Fed) or how the Fed understands its role, even if its two most important mandates, which are very clear, are price stability and low unemployment. At some point in time, during the tenure of Alan Greenspan, the communications from the Fed were so convoluted that analysts/economists would call Fed communications ‘Fed-speak,’ which basically meant that they could not understand a word of what Mr. Greenspan was saying!
However, today is different. The Fed has gotten much better at communicating what its thoughts are today and going forward. The only problem is that the Fed is like the family doctor: you call the doctor because you feel bad, and the doctor prescribes a very nasty medicine and says that you must take it all during the next several weeks.
Today, markets have been calling the doctor because they have an inflation problem. However, the medicine the doctors are recommending is too nasty to take, let alone do it for the next several months or even quarters.
We don’t think markets were surprised by the 75 basis point increase in the federal funds rate decided after the September Federal Open Market Committee (FOMC) meeting earlier this week. The Fed chairman, Jerome Powell and other members have been filling the airways with a more certain view of the path ahead. What happened after the FOMC meeting this week was that the Fed put a price or, as many would say today, ‘monetized,’ what Fed officials have been saying since the Jackson Hole meeting.
And markets did not like this monetization because it means higher interest rates for a longer period and probably a deeper recession than what they had already priced in.
On Deflation, Inflation, Stagflation, and Disinflation
But let’s try to understand why the Fed seems to have changed its mind about the need to move higher and stay higher for longer. First, it believes, and markets have made it clear, that it was behind the curve by not acting immediately to curb inflation after the inflation monster reared its ugly head. However, for an institution that has been fighting deflation for several decades, this is a ‘peccadillo’ that should have been pardoned already, but markets keep blaming the Fed for not acting on it.
Second, it has been hearing some analysts/economists throwing the word ‘stagflation’ out without any regard for the insurmountable differences that exist today compared to the 1960s, 70s, and 80s (See our Weekly Economics for June 10, 2022). If the Fed had bad policies that tended to perpetuate higher inflation for longer, what do we say about the bad, bad, even atrocious (political) policies pushed during the 1970s that worsened the effects of inflation and created a perfect storm for stagflation to take hold? Not saying that some of today’s policies are great, but nothing compared to what was happening then.
Having said this, the Fed is nevertheless concerned that if it does not act forcefully to control inflation today, high inflation will become the norm and inflation expectations will become entrenched at a higher level. So far, this is not happening, as shown by the different measures of inflation expectations, but it has become highly risk-averse regarding inflation.
Thus, the Fed doesn’t want to risk it and be accused of being soft on inflation as was the case with its colleagues of the stagflation period. That is, Powell and company don’t want to act as the Fed did during the 1960s, 70s, and early 80s and allow inflation to get the upper hand. It just wants markets to take the medicine in full rather than allow the ‘infection,’ i.e., inflation, to come back again and with greater force. And you cannot blame it for not wanting to be compared to those folks.
Third, the Fed, as well as many analysts/economists, were expecting inflation to start turning the corner at the end of the first quarter of this year (yes, this was the ‘transitory’ argument) but a new and unexpected external shock changed the timing for inflation to start coming down: the Russia/Ukraine war. Thus, the Fed doesn’t want another potential external shock to further undermine its inflation fighting credibility and has decided that this time around, it is not waiting for things to happen on their own, and it is ok with increasing interest rates further and pushing the US economy into a recession.
Fourth, because of all this, the Fed is expecting inflation to come down at a slower pace than what it was expecting before through a process that is called disinflation. And it is betting the house on its success. This is the reason why the strategy has changed to ‘higher for longer.’ The Fed has put out its worst-case scenario, something that should be music to the markets’ ears.
For the markets, this should be good news even if it is very difficult to see it at this point. Since this is the worst-case scenario for the Fed, any ‘better-than-expected’ news in the inflation front should be a boon for markets
NAHB Housing Index: The NAHB/WF Housing Market Index continued to decline in September, which is another clear indication of the impact of higher mortgage interest rates on sales of single-family homes. Additionally, we expect the other housing market releases this week (housing starts, existing home sales, and building permits) will show similar weakness. Bad news continues to be good news for the Fed, as it indicates its tightening cycle is working to slow demand. The NAHB/WF Housing Market Index dropped further in September to 46 from a reading of 49 in August, while consensus was expecting a reading of 48. This was the ninth consecutive monthly decline in the index, taking it further below the all-important 50 break-even level, suggesting additional deterioration in the US housing market. The index for current single-family sales remained above the 50-demarcation point, at 54, but the index for single-family homes in the next six months dropped to 46 compared to 47 in August. Similarly, prospective buyer traffic continued to shrink to a level of 31. Most of these indicators are hovering around their lowest levels since 2014 if we take out the decline induced by the COVID-19 pandemic in 2020. The only region that remained barely above the 50-demarcation point continues to be the South, with a reading of 52. Furthermore, the Northeast reported a reading of 48 compared to 49 in August, while the Midwest remained unchanged at 42, and the West dropped even further in September to 34. With mortgage rates continuing to increase and the NAHB/WF Housing Market Index remaining below the 50-demarcation level between expansion and contraction, the housing market is slowing down and is likely to continue to do so. Although the current single-family index for sales remained above 50, the forward-looking part of the index showed very weak expectations going forward.
Housing Starts & Building Permits: Housing starts bounced back in August after plunging in July, recovering to the June 2022 levels. While both segments (single family and five or more units) increased, multi-family housing led the charge as higher mortgage rates and rents are increasing demand for more affordable housing. On the other hand, building permits experienced the largest decline since the pandemic began in March 2020, reaching their lowest level since June 2020. Overall, tighter monetary policies continue to negatively impact the housing market and are making home ownership unaffordable to many. Housing starts in August increased to a seasonally adjusted annual rate of 1.575 million or a 12.2% increase compared to the revised July estimate of 1.404 million, according to the US Census Bureau and the US Department of Housing and Urban Development. This represents approximately the same level reported in August of last year. Single-family housing starts were 935,000 in August or 3.4% higher than the 904,000 million reported for July. On the other hand, building permits declined 10% in August, down to 1.517 million from 1.685 million in July. Compared to August 2021, building permits are down 14.4%. Single-family building permits were 899,000 in August, or 3.5% below the revised July level of 932,000. Building permits of five or more units were 571,000 in August, compared to 701,000 in July. Housing completions were at a seasonally adjusted annual rate of 1.342 million or 5.4% below the July revised estimate of 1.419 million, and 3.1% above the August 2021 rate of 1.302 million. With the average 30-year mortgage rate exceeding 6%, both builder sentiment (as shown in yesterday’s NAHB/WF release) and buyers’ ability to afford single-family homes continued to decline. Looking ahead, as the Fed continues to raise rates to tame inflation, the housing market is likely to get gloomier.
Existing Home Sales: Existing home sales continued to decline in August both on a month-over-month basis as well as compared to last year. Home prices for existing home sales were down compared to July but they are still positive year-over-year. Meanwhile, the supply of homes held steady, at 3.0 months, in August and on a seasonally adjusted basis. Existing home sales decreased by 0.4% in August, to a seasonally adjusted annual rate of 4.80 million according to the National Association of Realtors. Compared to August of last year, existing home sales declined 19.9%. The decline in existing home sales in August was less than what consensus was expecting. The median sales price of existing home sales was $389,500 in August, down from a median sale price of $399,200 in July. Home prices were up 7.7% versus August of last year for the US as a whole. Regionally, they were up 1.5% in the Northeast, 6.6% in the Midwest, 12.4% in the South, and 7.1% in the West, all compared to the same month a year earlier. Although existing home sales were stronger than the consensus expected in August, they were still down compared to July while the median price of existing homes continued to decline, a clear signal that the housing market continued to weaken in August.
Initial Jobless Claims: This was the first increase in jobless claims in several months, but claims remain at non-recessionary levels. This means that the labor market is still strong and higher interest rates are still not having the effects the Federal Reserve has been looking for. Initial jobless claims increased by 5,000 during the week ending on September 17, to a level of 213,000, according to the Department of Labor. This was the first increase in initial jobless claims since early August. However, the four-week moving average was still down, by 6,000 from the previous week, at 216,750. Meanwhile, the advanced seasonally adjusted insured unemployment rate was 1.0% for the week ending September 10 and unchanged from the previous week. There was no state reporting an increase of more than 1,000 claims during the week ended on September 10, 2022, while there were six states reporting a decline in claims of more than 1,000. The states were CA with 3,064 less claims but no sectoral comments; NY, with 2,905 fewer layoffs in the transportation and warehousing, health care and social assistance, and real state and rental and leasing industries; TX, with 2,493 less claims but no sector comment; OK with 1,729 less claims but no comments on the sectors affected; PA with 1,355 less claims in the transportation and warehousing, accommodation and food services, construction, and health care and social assistance industries; and GA with 1,337 less claims in the administrative and support and waste management and remediation services, transportation and warehousing, professional, scientific and technical services, and health care and social assistance industries.
Leading Economic Index: The Leading Economic Index (LEI) continued to point to a weakening US economy in August. We should continue to see weakness in the LEI in the coming months as higher interest rates continue to weigh on the strength of the US labor market. The Conference Board Leading Economic Index declined 0.3% in August, to 116.2, after posting a decline of 0.4% in July. This was the sixth consecutive monthly decline for the index and the Conference Board projects a recession in the coming quarters. This is because of the Federal Reserve’s (Fed) rapid tightening of monetary policy, which ultimately will have an impact on the labor market, as suggested by a Senior Director at the Conference Board: “Labor market strength is expected to continue moderating in the months ahead. Indeed, the average workweek in manufacturing contracted in four of the last six months—a notable sign, as firms reduce hours before reducing their workforce.” The Fed’s hawkish tone at the Federal Open Market Committee meeting on September 21 indicated that interest rates will be higher for longer, with a forecasted federal funds rate at ~4.5% by the end of the year. This LEI reading just confirms our view of a weakening economic environment in the US, and, with the Fed now expected to hike rates into restrictive territory, the US economy is likely to enter a recession in the next quarters.
DISCLOSURES Economic and market conditions are subject to change. Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results. Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample. Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior. Consumer confidence index is an economic indicator published by various organizations in several countries. In simple terms, increased consumer confidence indicates economic growth in which consumers are spending money, indicating higher consumption. The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. Leading Economic Indicators: The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non-governmental organization, which determines the value of the index from the values of ten key variables Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements. Source: FactSet, data as of 9/23/2022