The views and opinions expressed in this post are solely those of the author and do not necessarily reflect the views of the Georgia Institute of Technology or the Georgia Board of Regents.
Most of the economic data released this week was focused on the housing market – housing market index, housing starts, existing home sales, and building permits. But let’s be honest…the real focus this week was the meeting of the Federal Reserve Board of Governors and their interest rate decision.
Federal Funds Rate
On Wednesday, the Fed announced that they were leaving interests steady for now, but hinted that at least one more rate increase is to be expected this year. More importantly however, they now expect rates to stay higher for longer and suggested there would be fewer rate cuts next year than previously expected. The market had been pricing in as many as four rate cuts next year…that now appears very unlikely. As such, the market was off Wednesday and fell significantly on Thursday. The implications for federal, corporate, and personal debt are obvious…debt service will continue to be expensive and will impact everything from housing, to autos, to consumer credit, to corporate earnings.
But frankly, “higher for longer” shouldn’t be a surprise to anyone. Over the past 18 months, the Fed has raised the Federal Funds Rate by more than 500 basis points. This has been on of the steepest and fastest periods of rate increases since the Volcker Fed in the early 1980s. But even so, it was too little too late. The Fed was far too slow at raising rates sufficiently to combat inflation. In the past, during periods of high inflation, the Fed quickly raised the rates to a level ABOVE the inflation rate (see graph below). That is what was need to bring down the overall price level. However, this time, when inflation was at its peak in 2022, the Fed had only moved 200 basis points. In fact, it took more than a year for the Fed Funds Rate to exceed inflation and now, far from being under control, inflation is starting to move back in the wrong direction.
Why did the Fed move so slow this time? There are several possible reasons, but a big one may be the debt-to-GDP ratio (graph above). In previous periods, the level of federal debt as a share of GDP was relatively low, so increasing rates had minimal impact on federal debt service. However, when you owe more than 120% of GDP, raising rates has a huge impact on the level of debt service. As we have pointed out recently, the increase in rates has exploded the level of federal debt service to the point where this year, the federal government will spend more on debt service than they will on national defense….$1 trillion.
Federal Reserve Balance Sheet
Not many people have heard about the Federal Reserve Balance Sheet, but it has become an important tool in monetary policy. Traditionally, the Fed used the Federal Funds Rate (discussed above) to achieve their dual-mandated goal of stable prices and maximum employment. However, during the 2007-08 financial crisis, lowering this rate to zero wasn’t enough. As such, the Fed developed a new “tool.” They referred to it as “large-scale asset purchases,” but it is more commonly known as “quantitative easing” (QE). You may recall from the 2007-08 financial crisis the terms “QE1”, “QE2”, and eventually “QE3” – which at the time I referred to as “QE to infinity” because it was becoming clear that quantitative easing was never going to end. Under QE, the Fed enters the market and buys securities, e.g., mortgage-backed securities (MBS), treasuries, etc., injecting liquidity into the system. Or another way to put it….they create money out of thin air. These purchases are considered assets of the Fed and, as such, show up on their balance sheet. The graph below shows the balance sheet of the Fed since January 2003.
The green vertical bars indicate a new period of QE…the first three representing QE1, QE2, and QE3. In 2018, the Fed began an attempt to unwind these positions. However, in the spring of 2020, in response to COVID, not only did the reverse course…they EXPLODED the balance sheet by $3 trillion in just 4 months. They added another $2 trillion over the next two years for a total COVID-related expansion of $5 trillion. Where did this money go? Straight into the economy through:
- COVID Preparedness & Response Act – $8 billion
- Families First Coronavirus Response Act – $225 billion
- CARES Act – $2.2 trillion
- Paycheck Protection Program (PPP) – $483 billion
- Paycheck Protection Program 2 – $10 billion
- American Rescue Plan – $1.9 trillion
- “Infrastructure” Bill – $1.0 trillion
$5 trillion added to the balance sheet in just over two years. That is in addition to the $3 trillion that was added for the 2007-08 financial crisis. This is the basis for the current inflation that we are experiencing now. You can see this inflation in the money supply which grew 40% in just 2 years! Think about that….nearly 1/3 of all dollars ever created were created in the last few years.
You can see from both graphs that the Fed is trying to shrink the balance sheet. However, with the collapse of FTX in late 2022, and the failure of three small- to mid-size U.S. banks (The First State Bank, First City Bank of Florida, and Almena State Bank) in early 2023, the FED had to once again step in to prevent a potential global financial contagion. Which brings us back to “QE to infinity.” There will always be some crisis that the Fed will try to manage through expansion of their balance sheet. The Fed is no longer just a regulator and supervisor…it is now a full participant in the economy.
On Monday, the National Association of Home Builders (NAHB) released their Housing Market Index (HMI). The index is based on a monthly survey of NAHB members and is designed to “take the pulse” of the single-family housing market. Respondents are asked to rate market conditions for the sale of new homes at the present time; in the next six months; and rate the traffic of prospective buyers of new homes.
The HMI is a diffusion index that ranges between 0 and 100. A reading above 50 indicates a generally favorable market view and outlook in the industry. Last month the index sat right at 50, and it was expected to decline very slightly to just 49.5. However, the index dropped significantly down to 45.0 – an indication that higher interest rates continue to put pressure on housing market activity. (The rates on 30-year mortgages have settled above the 7.0% level, which is bearish for the housing market…and they are likely headed to 8.0%)
The next day, we got confirmation of the index when the Census Bureau released housing starts for August. Again, the expectations were for a slight decline to 1.430 million units from the 1.452 million pace in July. Instead, the number of housing starts plunged 11% to 1.23 million units, representing its lowest level since June 2020. Again, higher interest rates are starting to catch-up to a sector of the economy that so far has been somewhat resilient. According to RedFin, in August, 16% of home deals were cancelled as buyers got cold feet.
However, never underestimate the optimism of home builders! Even though housing starts are down, the housing market is down, and mortgage rates are high, building permits for housing jumped 6.9% in August to a seasonally adjusted annual rate of 1.543 million in August, the highest in 10 months and significantly higher than the expectations of 1.443 million permits. (However, on an annual basis, permits were still down 2.7%.) Single-family permits rose 2% and multi-family permits jumped 14.8%. Regionally, the south showed the slowest growth at only 3.9%.
This jump is interesting because the data on building permits give us an idea of the level of future construction activity. Given that the Fed has indicated that rates will be higher for longer, it will be interesting to see if builders take a pause next month with respect to pulling building permits.
Student Loans Are Starting Back
Finally, as September comes to a close, we need to remember that starting October 1, tens of millions of student-loan borrowers are going to have to start making payments that will average between $200-$300 per month. The Education Department instituted a pause on these payments back in March of 2020 as a response to COVID-19 and they have become a political football ever since. The restart of these payments will divert up to $100 billion from Americans’ pockets over the next 12 months, putting even more pressure on consumers who are already being squeezed as a result of higher prices and declining real wages. Last week we discussed rising credit card delinquencies and the increase in the number of credit cards that were “seriously delinquent.” A deeper dive into that data shows that people in the 18-29 and 30-39 age groups are experiencing the largest increases in “seriously delinquent” card balances. These are the very people who will have to start paying back student loans in October. Consumer spending is going to be impacted and perhaps finally the Fed will start to see the economic decline that they seem to be longing for.