The Fed is eyeing weaker home prices … it also wouldn’t mind your portfolio value dropping … Powell and his “Sophie’s Choice” moment … Larry Summers’ forecast about unemployment
Inflation sits at a 40-year high, melting away the buying power of your dollars like an ice cube on a hot June sidewalk.
The U.S. consumer is getting hit on three major fronts – energy costs (gasoline and home cooling), food, and housing.
Collectively, these three categories make up 63% of household budgets.
In the wake of the whole “transitory inflation” debacle, the Fed doesn’t just have a little egg on its face, it basically face-planted into a chicken coop. So, now it’s dead-set on redeeming itself by stamping out inflation.
Unfortunately, the Fed’s most powerful tools – interest-rate hikes and balance-sheet reduction – are blunt. Think “sledgehammer,” not “scalpel.”
What this means is these tools won’t have an immediate lowering effect on energy and food costs. It takes time for higher rates to trickle through the broader economy.
But housing? Well, that’s a different story.
***Why lower home prices are coming soon to a neighborhood near you
The Fed’s blunt tools have a far more immediate impact on the housing market.
That’s because a change in interest rates occurs instantly. As soon as the Fed takes action (and many times, even before the Fed takes action), markets adjust, sending their own rates higher or lower.
The obvious example is the standard 30-year fixed mortgage rate. In the wake of the Fed’s monetary tightening efforts, the average cost of the traditional 30-year mortgage has exploded.
As I write, it’s above 6% – double where it stood one year ago. We haven’t seen these rates since 2008. And with the Fed appearing trigger-happy on rate hikes, they’re likely to increase further.
This added cost is finally beginning to slow down the runaway housing market. Yesterday, we learned that existing home sales fell for the fourth straight month in May.
Existing home sales slid 3.4% from April to a seasonally adjusted annual rate of 5.4 million in May, compared to 5.9 million one year ago, according to data released Tuesday by the National Association of Realtors…
The number of homes sold has “essentially returned” to pre-pandemic levels seen in 2019 “after two years of gangbuster performance,” NAR Chief Economist Lawrence Yun said in a statement Tuesday, noting further sales declines should be expected in the upcoming months as rising mortgage rates add to affordability challenges in the housing market.
To be clear, housing prices are not cooling. Yesterday, we also learned that the average home price rose 14.8% from last year, hitting a record of $407,600.
But before actual prices fall, demand has to drop. And that’s what’s happening. So, the first domino has tipped.
First-time homebuyers are getting the worst of this. Whereas this time last year they accounted for 31% of U.S. home sales, last month that number dipped to 27%.
***In his press conference last week, the Federal Reserve Chairman was explicit about a housing reset being his goal
From Jerome Powell:
I would say if you’re a home buyer, somebody or a young person looking to buy a home, you need a bit of a reset.
We need to get back to a place where supply and demand are back together and where inflation is down low again and mortgages rates are low again.
So, this will be a process whereby we ideally do our work in a way that the housing market settles in a new place and housing availability and credit availability are at appropriate levels.
Now, let’s be realistic…
Powell isn’t the patron saint of first-time homebuyers. The truth is, he wants lower home prices for a reason that has nothing to do with first-time homebuyers.
In short, he wants existing homeowners to feel poorer.
***Powell wants a “reverse wealth effect”
To make sure we’re all on the same page, the “wealth effect” is a theory from behavioral economics suggesting people spend more money as the value of their assets rise.
It’s notable that this spending confidence happens even if income doesn’t actually increase one penny. As long as people feel richer – even if those gains are unrealized – they spend more. The opposite is true as well.
Given that the majority of the average American’s net worth is tied up in their home equity, the wealth effect is especially pronounced when it comes to home prices.
In the wake of the subprime housing crash, researchers at Northwestern looked into the “reverse wealth effect,” specifically, the impact of falling home values on consumer spending.
From the Chicago Booth Review:
…Consumption’s response to a change in house prices can be measured by looking at two variables: an individual’s marginal propensity to consume (MPC) as a result of temporary income changes (say, a salary bonus) and the value of her home.
High-debt, low-net-worth individuals typically have a high MPC, so a negative shock to home prices, especially at the peak of the housing market, would have a large negative effect on their spending.
Powell won’t say this, but he wants people to feel poorer. If they feel poorer, they’ll stop spending, which will alleviate inflationary pressures.
***You might be reading this and thinking: “Well, that study focused on low-net-worth individuals. Won’t medium- and high-net-worth individuals offset declines?”
Perhaps. But those chances decrease if the reverse wealth effect is nailing these higher-net-worth individuals where they’re more vulnerable…
The stock market.
The research paper “Stock Market Wealth and the Real Economy: A Local Labor Market Approach” finds that for every dollar of increased stock-market wealth, consumer spending rises by 2.8 cents per year. And again, the opposite is true, where falling stock prices tend to reduce consumer spending.
Powell and Co. won’t admit this, but they don’t mind today’s bear market in stocks. In fact, they want it.
A year ago, I would have told you that Powell didn’t want to be the guy who ended the bull market. Today, the bull market appears to be the least of Powell’s worries. I think he doesn’t want to be the guy who’s remembered for ushering in “the 1970s Part II.”
Given this, the “Fed Put” is gone. Powell and Co. are quietly comfortable with additional stock-market pain because of the reverse wealth effect and its dampening impact on inflation.
Here’s Forbes on this:
Inflation will go down if demand drops and/or supply increases.
Demand could drop if consumers and businesses spend less.
A drop in consumer spending could happen if the unemployment rate rises and/or the reverse wealth effect from plunging stocks and much higher gas and other prices convince people to spend less.
On the mention of “unemployment rate,” let’s pivot to one final way that the Fed could stamp out inflation.
***How the Fed might kill inflation by killing jobs
The Fed is having its “Sophie’s Choice” moment.
For younger investors, Sophie’s Choice is a film from the early ‘80s in which a mother has to choose which of her two children to save from death in a concentration camp.
What will the Fed save today?
The jobs market? The buying power of your dollars? We just noted how it’s unlikely to be the stock market.
Well, former Treasury Secretary Lawrence Summers believes we should sacrifice the U.S. worker.
From Summers, speaking last week in London:
We need five years of unemployment above 5% to contain inflation — in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment.
There are numbers that are remarkably discouraging relative to the Fed Reserve view…
The gap between 7.5% unemployment for two years and 4.1% unemployment for one year is immense.
Is our central bank prepared to do what is necessary to stabilize inflation if something like what I’ve estimated is necessary? …
The US may need as severe monetary tightening as Paul Volcker pushed through in the late 1970s early 1980s.
Right on cue, this morning Powell responded when speaking before congressional lawmakers, saying:
We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.
Of course, he conveniently hedged himself by saying “further surprises could be in store.”
Bottom-line, for all the carnage we’ve seen in the stock market, something else has to give before inflation returns to 2%.
On that note, I’ll add that economists surveyed by The Wall Street Journal now put the odds of a recession at 44% in the next 12 months. This is a level usually seen only on the brink of, or during, actual recessions.
And more than 60% of CEOs surveyed by the Conference Board last week said they expect a recession before the end of 2023.
So, whether it’s a recession, more stock-market pain, lower home values, rising unemployment, or some combination thereof, something else must give before the dust settles.
***Before we sign off, a quick note
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Have a good evening,
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