Still waiting for lower rates

If Fed Chairman Powell had competed in the 100-yard dash in last month’s Paris Olympics, we would still be waiting for him to finish the race. Step it up, Jay. It’s time to cut rates now.

Dr. John Rutledge
Chief Investment Strategist

Summary: July’s corrected CPI (2.0%) and PCE (2.1) inflation numbers, a string of weak Treasury auctions, and the massive 818,000 downward revision of the March jobs numbers show it is long past time for the Fed to push interest rates lower and suspend QE (stop selling bonds.)

Flash, Flash, 100-yard dash

I spent 3 hours at the California DMV last week trying to renew my Driver’s license. I say “trying to” because I have to go back again next week with note signed by my eye surgeon attesting that after he inserted new lenses in both of my eyes I can see like an eagle (20/15 distance vision) so it’s OK for me to drive a car.

There is one thing that’s more frustrating than standing in line at the DMV, however, waiting for the Fed to cut interest rates. For the past year, Chairman Powell has told each FOMC press conference that the Fed is data-dependent, that inflation is coming down nicely, and that they are almost, but not quite, ready to start cutting rates. Each press conference triggered convulsions in stock and bond markets. Now we are all holding our breath again until 2PM on September 18 when the next post-FOMC press conference begins.

The Fed should have started cutting rates a year ago. Here are a few of the reasons they waited too long:

• The Fed has become too self-aware; they confuse talking about monetary policy (Open Mouth Operations) with doing monetary policy (Open Market Operations). In the name of keeping inflation expectations “anchored,” the Fed orchestrates a stream of coordinated speeches by Fed Governors and regional bank presidents designed to “support” (manipulate) market psychology. Each speech is announced in advance, covered by the media, and dissected by the talking heads on TV. As Heisenberg told us, however, it is not possible to shine a light on something without changing its behavior. IMHO, turning Fed Governors into rock stars has not improved policy. It almost makes me pine for the days of William McChesney Martin when meetings were secret, and nobody knew the other Fed Governors’ names.
• The Fed has become too data-dependent, causing both the Fed and the market to attach too much drama to the release of each economic report. As I warned over a year ago, a cataclysmic event like COVID-19 overwhelms data collection, processing, and reporting procedures that were designed for normal times, leaving a trail of bad data in its wake. And bad data is tough to analyze on the fly. A good example was the big +353,000 new jobs number last January that caused the Fed to abruptly switch to tough talk about the need to cool the “hot” labor market, erasing hopes for a quick rate cut.

There goes the hot labor market! Daily Chartbook

• But last week the big jobs gains in the first half were revised away (chart above) when we learned that predicted new business formations that are built into every jobs report had failed to materialize. Not surprisingly, ADP payroll data showed that job weakness was concentrated in small businesses, especially vulnerable to restricted access to bank loans. Until considerable time has passed, no single jobs, CPI, or PCE number will tell us much about what is happening in the economy.
• And finally, the big one. The Fed has refused to admit a major flaw in the design of the CPI index that makes the monthly CPI report dramatically overstate the impact of rental costs on the cost of living (increasing its weight in the index from 7.6% to 36.3%.) If you correct the official indexes for this bias, inflation has been running near 2% all year. More on this below.

Example: July CPI/PCE

Last week’s July CPI report showed CPI inflation of 0.2% for the month of July and 2.9% over the previous 12 months. As you can read below, however, 90% of the 1-month increase was accounted for by shelter, which carries a 36.3% weight in the index and increased 0.4% for the month.

Shelter accounted for 90% of July’s CPI increase (BLS)

About one-quarter of the shelter number (7.6% of the index) represents legitimate expenses for rent paid by people who actually rent their residence by writing a check to someone else; these costs should stay in the index. But 3/4 of shelter costs (26.8% of the total index) is made up of “Owners’ Equivalent Rent” (OER), a number that has been invented out of thin air by pretending that, as the owner of my house, I pay rent every month to myself equal to a guess at what I might have had to pay to rent my house if I didn’t own it. (Whew!) But in the U.S., 40% of U.S. households own their own home with no mortgage, i.e., they don’t write a check to anybody. And another 30% own their home financed by a fixed-rate mortgage below 4%, the legacy of waves of refinancing that took place during the ZIRP (Zero Interest Rate Policy) years.  As I have written many times over the past 2 years, IMHO the entire concept of OER is ridiculous and should be thrown out of the index.

Removing OER from the July CPI index results in a 1-month inflation of 0.1% and a 2.0% increase over the previous 12 months, exactly equal to the Fed’s announced target. In case you’re wondering, the same logic applies to the PCE—the Fed’s favorite inflation index. Removing OER from the July PCE index reduces the reported all-items 12-month inflation rate from 2.5% to just 2.1%, where it has been for months.

New York Prices

So, if inflation is already so low, why are people so angry about inflation?

One night last week, I was walking from the restaurant where my old friend Larry Kudlow and I had just eaten dinner back to my hotel and I spotted an ice cream truck with an offer I couldn’t refuse. A small cone with a single dip cost me $10 including tip! (Okay, it was dipped in chocolate, but still…) I found myself getting angry too!

And it wasn’t just the ice cream. Every other thing I bought in New York was expensive too compared to the last time I had bought it.

There is a difference between high prices, which measures how much it costs to buy something, and high inflation, which measures how fast prices are rising. My $10 ice cream cone tells me that prices had risen a lot (inflation had been high) since I last bought one. But it doesn’t tell me whether the price is rising or falling today.

The same goes for the CPI. The CPI at the end of 2023 was almost 20% higher than it was at the end of 2019, just 4 years earlier, before the arrival of COVID-19. The fact that it is increasing more slowly now (the 2.0% 12 month inflation rate I calculated above) doesn’t make things any less expensive today. People are angry today because, on average, they can’t afford to buy the things they need to feed their families!

So, Why Lower Rates Now?

So, if things are expensive today, why do I want the Fed to lower rates, rather than raise them and bring the high prices down?

• Reason number 1: because, at least since Irving Fisher, we have known that periods when prices are actually falling, i.e., deflation, as opposed to flat or rising, are very, very painful. Falling prices erase the dollar value of the collateral backing loans, lead to foreclosures, bankruptcies, and bank failures, and throw people out of work. That’s why central bankers are always, everywhere, allergic to deflation.
• Reason number 2: because monetary policy works very slowly. Recent estimates from the Federal Reserve Bank of San Francisco (FRBSF) suggest that only about half of the impact of high rates has worked its way through the economy, i.e., the tightening the Fed has already done will continue to put downward pressure on output and inflation over the next 2 years. We need to reduce rates now to avoid adding to that pressure.
• Reason number 3: because the Fed doesn’t do supply. About half of the increase in prices since 2019 was caused by the increase in demand that resulted from Fed stimulus and checks in the mailbox during the COVID-19 years. But the other half was caused by production shutdowns, a decline in labor force participation, closed ports and other supply-chain problems. Although much of those supply constraints have now been resolved, there are still major supply-chain blockages in the Suez Canal (Houthis) and the Panama Canal (low water level). Even today, demand is only responsible for about half the current 2% inflation rate. The other half reflects supply-chain issues outside the Fed’s control/jurisdiction.

It has been understood, at least since the 1973 oil embargo, that when prices rise as a result of supply shortages, it is a mistake for the Fed to try and reverse them by tightening policy. To do so would worsen the output loss caused by the supply constraint. And since supply constraints tend to be one-off, temporary events that don’t typically lead to sustained increases in prices over longer periods, it is better to wait them out.

Bottom line: the Fed’s job is to manage demand, not supply. That job is done for now. It is time for the Fed to push the Fed funds rate lower and suspend QE. Doing so now would help to take pressure off regional banks as they work their way through refinancing the underwater commercial real estate loans on their balance sheets and prevent today’s tight bank small business loan market from freezing up.

As a betting man, I think the Fed will cut rates by 1/4% in September, not enough but a start at lowering rates. Accordingly, the bulk of my portfolio is comprised of assets that will do well during an extended period of falling rates. But history suggests there is still a meaningful chance the Fed will blow it and fail to reduce rates at all, which would trigger a major selloff in the equity markets. To protect against that case, I am still keeping a big cash position so I can scoop up quality assets at discount if it all goes the wrong way.

Dr. John

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.