As expected, the Fed “paused” at its September meetings. And while the Fed’s administered rates did not change, the markets interpreted this as a “hawkish” pause, and market rates across the spectrum rose in the aftermath of the Fed statement and the Powell press conference. The “hawkishness” can be seen in the dot-plot chart. The gray dots are the views of the 19 FOMC members as of June for the end of 2023, 2024, 2025 and long-term. The yellow dots are as of the September meeting. The gray line is the median view as of June, the green line as of September. The dot-plot clearly shows the “higher for longer” mantra.
While the forecast for Headline CPI remained the same as in June, the justification for “higher for longer” interest rates was the upward revisions to the Fed’s GDP forecasts, both for the remainder of this year and for 2024. Powell attributed the upward revisions to “strength in consumer spending.” (Readers of this blog know that we have a different view of consumer strength – more on that below).
The range in the dot-plot is also interesting. For the end of 2024, the range is from 4.5% to 6.25%. There is no Recession penned in. For the end of 2025, however, the range is 2.75% to 5.75%. And, clearly, a few of the FOMC members see a Recession forming over the next couple of years. It appears that the strength Powell sees in consumer spending is the result of looking through the rear-view mirror, at past data. He doesn’t see the exhaustion of the “excess savings” (i.e., the free money from 2021 and 2022) and clearly isn’t considering the restart of student loan debt repayments in October.
Our view is that emerging economic weakness has already appeared, it is just starting in the U.S., but is clearly underway both in Europe and China, and is just emerging in Japan.
Controlling Market Sentiment
As we have written in past blogs, prior to 2012, the Fed never discussed its policy moves with the markets. The minutes of Fed meetings weren’t published for several years. There was no FOMC statement and no press conference. FOMC members didn’t comment on policy in their speeches.
Since 2012, with the initial publication of the dots, the FOMC statement, the press conference, and various public speeches by FOMC members, the Fed has had to “manage” market expectations. Today’s inflation data is clearly moving in the right direction (even acknowledged by Powell), and the Fed is clearly closing in on its inflation goals. But any such enthusiasm could cause markets to pre-empt the Fed and move market rates down before the Fed desires. Thus, the “hawkish” pause and the emphasis on “higher for longer.” As a result, in the post-2012 era, besides its monetary policy duties, the Fed has the new task of managing market expectations so that markets don’t pre-empt policy.
Thus, it is our view that the dot-plot and the higher growth projections were part and parcel of the Fed’s need to manage market expectations. And because of this need to manipulate market sentiment, their forecasting track record has been poor.
The Money Supply
Besides interest rates, the Fed also controls the money supply. At the press conference, Powell said (several times) that the Fed would continue to reduce its holdings of U.S. Treasury securities (i.e., continue Quantitative Tightening (QT)).
The chart shows the year-over-year changes in the money supply, in this case M2. (M2: cash, demand deposits, time deposits, money market funds…) Note that since the 1960s, M2 has touched the 0% growth line only twice, both in the 1990s. But M2 growth has never contracted like it has in 2023. Monetary economists (Milton Friedman school) believe that the money supply is quite influential in economic growth and inflation. If one looks at the right-hand side of the chart, one can see the explosion of M2 during the pandemic. So, if you believe in Friedman’s ideas, it isn’t any wonder that we’ve had inflation. But, now, for the first time, at least since the 1960s, the growth rate in M2 is negative. Again, for monetarists, it isn’t any wonder that inflation is melting. But wait!! The chart also shows that Recessions are usually associated with a reduction in the M2 rate of growth. So, the M2 contraction is telling us something sinister.
The fall in M2’s growth to negative territory is corroborated by the meltdown of commercial bank deposits. Like M2, in modern history, there was only a brief period in the 1990s where commercial bank deposits contracted. It was brief and mild. Again, like the M2 chart, you can see the impact of the money giveaways during the pandemic (right-hand side). The free money was in the form of checks drawn on the Treasury which the public deposited in their banks.
Bank deposits are now in a negative growth pattern as the Fed continues to reduce the money supply by $100 billion/month by selling Treasury securities from their portfolio. (The Fed sells the Treasury Note; the buyer pays for it with a check; the Fed clears the check by reducing that bank’s deposit at the Fed. That money has disappeared!) Note: as deposits contract, the ability of banks to lend diminishes.
Similar to the money supply, the following chart shows a negative pattern with federal tax receipts. On the right-hand side, note that tax receipts fell during the initial stages of the pandemic. They then rose at a record pace as the economy reopened, but are now falling, much like the pattern you can see during the Dot.Com and Great Recessions.
Incoming Data and Economic Growth
In other economic news:
- Real Retail Sales (adjusted for inflation) showed up as -0.1% in August vs. July. In their Q2 reports, all the major retailers talked about a hesitant consumer, now trading down, and excess inventories. And the rise in the price of gasoline alone (+10.6% in August) will sap other retail sales.
- The robust consumer spending we saw in Q2 is now fading as the fiscal giveaways (“excess savings” as the Street likes to call them) get exhausted. While Q3 consumer spending might still show a little verve, the fact that the savings rate is down to a 3.5% low and credit card balances are at record highs speaks to the inability of consumers to continue to increase consumption.
- The restart of student loan debt payments in October will only drain more from consumer budgets. We estimate this will shave -0.5% from consumption.
- Housing Starts fell -11.3% in August from their July levels. This is the lowest level since June 2000 and starts are off -15% year/year. Single-Family starts fell -4.3% in August from July’s level while Multi-Family starts melted -26.3%.
- The next chart shows that vacancy rates for rental units have begun to climb. And with the record number of new apartment units headed for completion, we expect that rents will continue to fall. So, it isn’t surprising to us that new housing starts, especially Multi-Family, are tanking. And that should continue to put downward pressure on Headline and Core Inflation.
- There has been a manufacturing malaise worldwide. This includes the U.S., Europe, and China. It appears that China and Europe are already in Recession. The latest Philly Fed Manufacturing Index (September) was -13.5. Its New Orders sub-index was -10.2, and the Employment sub-index was -5.7. This continues the streak of weakness seen in the Regional Federal Reserve Banks’ manufacturing surveys.
- The Conference Board’s Leading Economic Indicators (LEI) have now been negative for 17 months in a row. This indicator has a 100% track record in forecasting Recession when it shows such a streak of negative readings.
- For the U.S., rising interest rates relative to the rest of the world pushes up the value of the dollar, good for U.S. travelers abroad, but quite poor for the nation’s export industries.
- And then we have the ongoing UAW strike. The union’s demands appear so far out in left field that this appears to be the beginning of a long, drawn-out affair. Not good for economic growth.
- And, finally, while still only a threat, the potential for a government shut-down is also a large negative for economic growth.
Inflation
We aren’t the only ones who see significantly lower inflation, if not deflation, over the next couple of years. According to Economist Ed Yardeni, if rents were excluded from the CPI calculations, Headline CPI would be 1.9% and Core 2.2% (right-hand side of chart). As we indicated in last week’s blog, our own calculations show that Headline CPI for August would have been +1.2% if the Apartment List Index were substituted for the antiquated and stale BLS shelter number.
Final Thoughts
- The Fed is winning the market sentiment fight. It has convinced markets that, despite progress on inflation, interest rates will remain “higher for longer.” Markets raised rates across the yields curve in the aftermath of the Fed meeting/statement/press conference.
- The need to manipulate market sentiment often makes Fed forecasts inaccurate. We think their “soft-landing” forecast for 2023 and 2024 was a straw man, used to convince markets that interest rates will remain high. At this time, the Fed appears to have won the PR game.
- Inflation continues to melt. Excluding BLS’s biased shelter cost index, CPI’s August Headline would have been +1.9%, and Core, +2.2%. And, if a realistic rent index were used, August’s year/year number would have been somewhere near 1.2%.
- Besides melting inflation, incoming data, including falling M2, falling bank deposits, falling tax receipts, falling housing starts, rising vacancy rates, flat retail sales, a manufacturing malaise, and 17 months in a row of falling leading indicators convince us that “higher for longer” will go the way of “transitory” by the middle of 2024.
(Joshua Barone and Eugene Hoover contributed to this blog)
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