Interest Rates Have Peaked

Summary: Forget Powell’s tough talk at last week’s FOMC press conference. Interest rates are heading down from here. Excluding homeowners’ imaginary shelter costs (Owners’ Equivalent Rent, or OER), the May CPI report shows inflation of (-0.1%) between April and May, and 2.6% over the previous 12 months. Falling rent and a cooling labor market will push inflation still lower in the months ahead, setting the stage for rate cuts, reduced recession risks and continued strength in stock prices in the second half.

Show Time!

Wednesday’s FOMC meeting was tightly choreographed to blunt the market’s likely positive reaction to the decision we all knew was coming not to raise the Fed funds rate. The press release gave us the good news—no rate increase but they would keep shrinking the balance sheet by selling $95 billion of bonds every month. Powell’s press conference took it back.

At the press conference, Powell reminded us with a stern face that they are the leanest, meanest bunch of inflation-fighters around. He told us twice that “nearly all Committee participants…” still want to jack up rates a couple more times this year and mentioned during the Q&A that they probably won’t lower rates at all for the next couple of years.

Then he hauled out the dreaded dot plot chart, above, showing that 16 out of the 18 FOMC participants—whose track record proves they are not good at forecasting anything (remember “transitory inflation?)—can feel it in their bones that the Fed funds rate will end the year higher than it is today. The reporters in the room were appropriately somber. The stock market had a Monte Python moment (“Thank you for skipping the chance to beat me again today, master.”); prices fell a little. Mission accomplished.

Where Does That Leave Us?

The fact that the Fed left the funds rate unchanged means they are worried about the damage they have done to the banking system and credit markets. The tough talk is their attempt to defend their macho image. But their tough words have no information value, both because the Fed has no ability to forecast future economic conditions and because they have repeatedly told us they are “data dependent”, i.e., they will do whatever the data tells them to do at the time. In the months ahead, the data is going to tell them it’s time to cut rates.

The Fed has become far too self-aware, keenly focused on the impact their words have on stock, bond, and real estate prices. That is a mistake. I believe that Fed efforts to “manage” market expectations, whether through the wording of official releases or the highly orchestrated speeches given by Fed Governors and regional bank presidents, undermine their already-shaky credibility. And it perverts the very notion of rational expectations that supposedly forms the backbone of their policy framework. IMHO, they should stop practicing their speeches in front of the mirror and back away slowly from the microphone.

Time to Stop Raising Rates

As you know from my recent posts, I believe the Fed has raised rates too much, too fast, and that it is not going to be possible for the Fed to keep rates this high and continue to sell bonds without doing more damage. My bet is they will be forced to declare victory on inflation and start reducing rates as early as this fall.

It is never a good idea to take aggressive action without good information, but that’s what the Fed did when they decided to raise rates. The pandemic undermined the reliability of the data we all use to make judgments about the economy in at least three ways:

• The impact of COVID on the economy undermined the integrity of seasonally-adjusted data. Three years of huge intra-year swings in economic and financial conditions mean standard seasonal adjustment procedures—such as pruning “outliers” from data sets—can be misleading, as we saw earlier this year with both employment and inflation data. In a pandemic, the outliers are the story. Until sufficient time has gone by for one-time pandemic anomalies to flush through the data, seasonally-adjusted data are of little value. Until then, focus on unadjusted data.
• Second, COVID, the war in Europe, and US/China decoupling have interrupted global supply chains in ways we are still trying to understand. Interesting analysis from the San Francisco Fed (see chart below) suggests that supply constraints may be responsible for as much as half of overall inflation over the past three years. Demand-driven inflation—the only kind Fed policy is designed to control—may already be at or near the Fed’s 2% target.
  
• Third, for reasons I outlined in a recent post, (Bad Data: The Case of the Consumer Price Index), I believe the Fed is targeting the wrong measure of inflation. More than 25% of the CPI market basket is made up of Owners Equivalent Rent, a thoroughly fictional metric invented to represent the imaginary opportunity cost of living in your own house instead of renting it out to someone else. By my calculations, the use of OER overstates CPI inflation by 2% and PCE inflation by 1%. Excluding OER, the May CPI report shows that seasonally adjusted consumer prices actually fell a little (-0.1%) between April and May, and increased by just 2.6% over the previous 12 months. OER alone accounted for almost half (1.9%) of May’s 4.0% 12-month inflation rate.

This is Good News for Investors

The Fed knows there is something wrong with the inflation figures, which is why Chairman Powell talks about lagging apartment leases in his press conferences and the BLS now reports a special index for “All Items Less Shelter” in Table 3 of the CPI report. But the Fed is not going to change the way they measure inflation just because I think it’s a good idea—they have too much invested in current procedures. They are going to stick with the current CPI and PCE indexes-OER and all—until the bloody end.

This is bad news for the economy but good news for investors because it gives us advance warning about what the Fed is going to do later this year—they are going to be lowering the Fed funds rate.

Why? First, OER is a number that has been completely fabricated out of survey data on apartment rents. Second, as Chairman Powell told us, data on apartment rents only reveals changes in rental agreements with a lag because about 60% of lease contracts are renewed only once every 12 months. Third, the big surge in rent inflation peaked more than a year ago and has been falling since then. Together, these facts give us visibility over the downward path that OER-polluted inflation indexes, like the CPI and PCE, will follow over the next year.

The shelter cost component of the CPI (responsible for 66% of the 4.0% inflation in the May CPI Report) will be on a steep downward path for the rest of the year. That means the Fed and the markets are going to see a series of happy inflation surprises (lower than forecast). Add to that the cooling labor market that the Fed is wrongly fixated on as a source of inflation (Wages don’t cause prices; wages are prices) and the stage is set for the Fed to declare at least partial victory over inflation and begin to lower rates this fall. That will be welcome news for the markets, will reduce recession fears, and give support to stock prices in the second half of the year. If I am wrong and the Fed insists on holding rates too high in the face of falling inflation data, credit conditions will worsen, growth will slow, and rates will come down even faster next year.

Dr. John

Postscript: I have to admit being confused about how much technical information to include in this post on this strange creature called OER. When you follow the trail of breadcrumbs leading from the footnotes in the CPI report, through the Personal Income and Outlays report, and the national income accounts, you end up in the fine print of the NIPA Handbook, which ultimately refers you to a UN report that tells you that the international agencies adopted OER to make it easier to compare national income statistics across time and geographies that have different rental/ownership proportions. I will describe those procedures in detail in a later post with a clear warning for those who choose not to read it. Although I have some sympathy for those who designed OER as an attempt to measure the annual flow of housing services in the GDP accounts, I have less for its use in constructing measures of personal income and personal outlays and none whatever for its use in constructing price indexes. More on this in a future post.

The views and opinions expressed in this article are those of Dr. John Rutledge. Assumptions made in the analysis are not reflective of the position of any entity other than Dr. Rutledge’s. The information contained in this document does not constitute a solicitation, offer or recommendation to purchase or sell any particular security or investment product, or to engage in any particular strategy or in any transaction. You should not rely on any information contained herein in making a decision with respect to an investment. You should not construe the contents of this document as legal, business or tax advice and should consult with your own attorney, business advisor and tax advisor as to the legal, business, tax and related matters related hereto.