Week In Review: More bad news on inflation

Last week was tough for stock and bond markets, as the economic data is not showing much of a retreat in either the labor market or inflation. Inflation at the consumer level rebounded in January, while the economy added over 500,000 jobs. This has caused the bond market to become much more hawkish.

The PCE Price Index (the Fed’s preferred measure of inflation) came in higher than expected, and the Fed minutes showed there were “a few” participants who wanted to see a 50 basis point increase in the Fed Funds rate.

Loretta Mester gave a speech discussing the economy and monetary policy. The statement that caught everyone’s attention was her statement that she saw a “compelling economic case” for a 50 basis point hike in February.

On the risks the Fed sees to their policy:

“Several private-sector forecasters do not expect inflation to return to 2 percent until sometime next year.  According to the median in the December FOMC Summary of Economic Projections, this goal will not be reached until 2025.⁴ If that comes to pass, it means that inflation will have been above 2 percent for over 4 years, and well above 2 percent for much of that time.  Even that forecast could turn out to be optimistic. Some recent research by economists at the Cleveland Fed presents a plausible case, based on a model and historical relationships in the data, that inflation could end up being much more persistent than current projections, despite the actions the FOMC has taken”

Essentially the message is that inflation is probably going to last for another two years. Given the strength of the labor market, we will probably see a wage-price spiral start to take shape. If the Fed kicks off a recession, they think that is probably an easier battle to fight, so the Fed is going to err on being too tight.

This is much more hawkish than the market had been thinking. The market has taken the deceleration in rate hikes to be a signal the Fed is wrapping up this tightening cycle. While Fed Funds futures have been hiking the forecast for the end of 2023, they still thinks the rate maxes out 75 basis points from here or a range of 5.25%-5.5%. If you go out to the December 2023 futures, the markets see rate cuts in 2023.

This seems to be off-base. The only way rate cuts are possible this year is if we hit a sizeable recession, pronto. The labor market is still tight as a drum, which isn’t recessionary material. Retail sales were healthy as well. While there are always risks of a black swan in the financial markets, credit spreads are generally tight, which means we don’t have a lot of financial distress out there. If a deep recession is coming, I don’t see it, certainly not in the near term, and if we aren’t getting a recession in the near term, we won’t be seeing rate cuts this year.

The January Consumer Price Index came in higher than expected, with a big rebound in the month-over-monthly number. Ditto for the Producer Price Index. Of course with the Fed, the number to watch is PCE inflation, but they still pay attention to CPI / PPI. Housing services remain an issue, however the Fed thinks that will fade as we head into summer. That said, the Fed is concerned mainly about services ex-housing, which is wage growth.

Housing starts came in at an anemic annual pace of 1.3 million units per year. The affordability issues have caused a big drop in new home sales, and the builders are holding off on new construction.

The amount of units under construction is still at multi-decade highs, which is highly surprising when you think of the state of housing market over the past decade. The perception has been that the housing market has been underbuilding and yet if you look at apartments under construction, we haven’t.

In fact the last time units under construction were so high was the early 1970s. Which is the model for the period was are probably experiencing.

The National Association of Realtors thinks we have an underbuilding gap of 5.5 - 6.8 million units, so even the 1.7 million units under construction are still less than a third of the low estimate for demand. And 1.7 million units isn’t a lot in the context of 5 million existing home sales per year.

Still, the population was a lot smaller in the early 70s than it is now. Just for fun, I corrected for population growth, and today’s levels are about 33% below the peaks of the 1970s. Still it indicates that a lot of supply is going to be dumped on the market, especially since we added about 500k units since the beginning of the pandemic. The big question is whether this is a nationwide issue or a specific-market issue. I suspect a lot of these units are in Phoenix, Miami, San Diego, and those markets have seen big-time home price appreciation since COVID.

Still, does it feel like units under construction are the highest since the Nixon Administration? Does it feel better than 2005-2006? We are in a housing recession, and nobody is calling this current environment a strong housing market. Prices are supposedly falling sharply in some of these overheated markets, but a seasonal drop in prices during the winter is normal. We’ll see if price cuts are happening as the Spring Selling season gets under way.