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As the Economy Softens and Inflation Retreats, the Fed’s “Higher for Longer” Looks Likely to be a Policy Mistake

Q1’s real GDP was light at 1.6%. Per Economist David Rosenberg, it would have been closer to an annualized stall speed of +0.5% had it not been for a drop in the savings rate from 4.0% to 3.6% (was 5.1% in last year’s Q2).  Market expectations were for a more robust 2.4%, especially coming off of Q4’s growth rate of 3.4%; so quite the deceleration. In the quarter, consumption, the major GDP player, grew 2.5%, again lower than Q4’s 3.3% growth, and under the 3.0% rate penciled in by Wall Street.

Normally, bond yields fall under such conditions, as slowing economic growth implies that interest rates will move lower. Not this time! Bond rates rose (see chart) because the core Personal Consumption Expenditure (PCE) deflator, a key inflation gauge that the Fed closely monitors, showed up at an annual rate of 3.7%. The consensus estimate was 3.4%, and that gauge only rose at an annual rate of 2.0% in Q4.  Most of the nasty inflation data was confined to housing/utilities, financial services, and healthcare which, together, rose at a 6.2% annual rate. Excluding these, the core deflator rose at a +1.5% annual rate, well below the Fed’s 2% goal. The prices of goods actually deflated (durable goods at -0.5% and non-durables at -0.6%) (see charts). And while services inflation is on a downswing, it is still pulling overall inflation higher than the Fed’s 2% target.

As a result, the bond market now sees the Fed’s first rate cut occurring in December at the earliest. We don’t agree. As explained below, disinflation appears inevitable over the remaining course of the year. Note, as an example, what has happened to one of the poster-children for this bout of inflation, used car prices (down nearly -14% from its early 2022 peak). Thus, it appears to us that the rise in interest rates this past week was an overreaction which will reverse itself, especially as economic growth continues to falter. Our reasoning comes down to this: all of the nasty inflation data were confined to services which are subject to a lot of imputation (guesswork) rather than direct price observation. As detailed below, using Europe’s better inflation methodology results in an inflation rate already below the Fed’s 2% objective.

In the recent past, consumption has been supported by “excess savings” which arose from the cash gifts from Uncle Sam in 2022, by an upturn in credit card borrowing, and from a low savings rate. Over the last few quarters, those “excess savings” have been spent. And, as we have commented in past blogs, now we see consumer delinquency rates (autos and credit cards) rising swiftly, a record rejection level of applications for increased credit limits, and no new cash gifts from Uncle Sam anywhere in sight. It thus appears that it is only a matter of time before we see a significant downshift in consumer spending. In fact, for those retailers already reporting Q1 earnings, the recurring theme has been a resurgence of consumer frugality (trading down, resistant to price increases, etc.).  As a result, it appears to us that both inflation and economic growth will soften as the year progresses.

CPI vs. HICP

In past blogs, we’ve commented on the flawed way in which the CPI is calculated. It uses very lagged rent data, including something called Owners’ Equivalent Rent (OER) which is a single survey question with a large weight in the CPI. The survey asks homeowners to estimate the rent they could get if they rented out their home. Most homeowners are not experts in their local real estate markets, and with all the hype about rising home prices, the result appears to be biasing the CPI to the upside.

European countries’ CPI equivalent is called HICP (Harmonized Index of Consumer Prices). Because it isn’t observable, HICP excludes OER. In his April 22nd Breakfast With Dave commentary, Economist David Rosenberg observed:

When the core CPI methodology is modified to include how the Europeans calculate

inflation, on an apples to apples basis, the Year over Year trend in the U.S., at 1.9%,

is already below [the Fed’s] target.

Note in the chart the huge difference that has opened up between the indexes, largely due to the lag in the BLS’s rent index and also to the inclusion of OER in the CPI but not in HICP. According to the HICP methodology, the inflation dragon appears to have been vanquished.

As we have noted in the past, the Fed has a significant number of economists on staff. They certainly are aware of the flaws in the CPI calculations. Also remember that the Fed believes that the “neutral” Fed Funds rate (at which policy is neither accommodative nor restrictive) is near 2.6%. Logic tells us that as soon as they are convinced that the inflation genie is back in the bottle, they will start to move interest rates to that neutral level. That’s nearly 300 basis points (3 percentage points) lower than today’s Fed Funds rate. Thus, even if we do get a “soft landing,” (not our base case scenario), the Fed will still have to move rates down significantly. And if we get a Recession (our base case), then they will have to move rates well below the “neutral” level.

Yet, despite the incoming data beneath the headlines, they have communicated “higher for longer,” and have convinced markets of such. This is also in the face of a slew of indicators pointing to economic slowing. Besides the recently released Q1 GDP discussed above, these include the Chicago Fed’s National Activity Index and the Conference Board’s Leading Economic Indicators.

This leads us to ask: “Is there another agenda?” Are they still worried about their misdiagnosis (Inflation is “Transient”) and its impact on their credibility or reputation? Or, are they targeting something more. Rosenberg thinks they have their sights set on home and equity prices. Given the evidence that inflation’s back has been broken, such thoughts have credence.

Banks and the CRE Issue

On Friday (April 26th), Republic First Bank of Philadelphia ($6 billion in assets) was closed by the Pennsylvania Department of Banking and Securities. Its assets and deposit liabilities were purchased by Fulton Bank NA of Lancaster, PA. The cost to the FDIC is estimated to be $667 million. We feature this because we believe that there are many banks with substantial loans made on Commercial Real Estate (CRE) collateral. The first chart below shows the rapid fall in the value of CRE, making such loans less secure. The second chart shows the oncoming corporate refinancing wall. The volume of refinances will have a large negative impact on total corporate profits due to much higher interest rates than those that are rolling off. With values falling and interest rates near 21st century highs, CRE defaults will inevitably rise. How many banks will fail as a result is anyone’s guess. What we do know is that Republic First Bank won’t be the last failure in this cycle.

Final Thoughts

The European method of calculating the rate of inflation (HICP), which eliminates the imputation of Owners’ Equivalent Rents, results in a Core HICP for the U.S. that, at 1.9%, is already under the Fed’s 2% target. And, when we see used car prices nearly -14% lower than a year ago, we are convinced that the inflation dragon has been slain.

Manufacturing continues in its Recession. The latest Kansas City Fed Survey of Manufacturers printed its eighth consecutive contraction in April. The latest Wall Street earnings reports have almost universally guided Wall Street lower on sales and the retailers have maintained that consumers are tightening purse strings.

If the Federal Open Market Committee (the rate makers) is headline driven, i.e., doesn’t pay attention to the detail, then rates will be “higher for longer.” We think that will be a policy mistake that could result in serious economic issues (in banking and result in a Recession).  It appears that lowering rates toward their “neutral” level is inevitable; the only question remains is the timing.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog.)

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