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Tamer Inflation

But Trouble Lies Ahead as Fed Has Overtightened

As we go to press, the Fed has called an Emergency Meeting for Monday, October 3. The official reason is a “Review and determination by the Board of Governors of the advance and discount rates to be charged by the Federal Reserve Banks.” Our view is that the international chaos that the Fed’s hawkishness has caused in the European community via unprecedented dollar strength and rising rates there has caused significant issues in one or more major banks there. (The Dodd-Frank legislation in 2012 required much more capital in U.S. banks, but this isn’t true for Europe.) We note that credit default swaps (CDS) for Credit Suisse are at 2009 levels. We speculate that we may see some reversal of the recent hawkish view of future rates.

Markets have tanked since the worse-than-expected CPI reading caused more Fed hawkishness.  And it doesn’t look like the economy will have a “soft-landing.” Unprecedented dollar strength is also causing major issues in the currency markets. The DOW, the S&P 500, and the Nasdaq all closed below their June lows on Friday (September 30); only the Russell 2000 remains above those June lows (see table). Granted, there was end-of-quarter selling by fund managers not wanting to show a lot of equity holdings in a down market. So, there may be an equity bounce early next week from “oversold” conditions. But this is truly a “Bear Market,” and the break below the June lows is not good news.

   PeakMid-June lows chg fr Peak  9/30/229/30 chg fr Peak
S&P 5004,7973,667-23.6%3,606-24.8%

In the fixed-income markets, things are no better. Short-term 2-Yr T-Note yields got to 4.40% on Tuesday (September 27) – and were as low as 4.14% early Friday morning. Because no one wanted to be long anything going into the weekend, they closed at 4.27%.

Long-term (30-year) Treasuries closed at 3.78%, much lower than the 2-Yr.  This is called an inverted yield curve and only happens when the Federal Reserve is over-tightening. The inverted yield curve is a very reliable indicator of an oncoming Recession.

As we’ve said in past blogs, the Fed appears to be fighting yesterday’s war. The July and August CPI, taken together, were 0%. That said, On Friday morning (September 30), the Fed’s preferred gauge of inflation, the PCE (Personal Consumption Expenditures) Index came in at a mild +0.3%.  Core PCE inflation (ex-food & energy) rose 4.9% Y/Y. The trouble in the report was the M/M core rate rose 0.6%. Now, this is a mixed message. The Y/Y isn’t bad, but the monthly is. So, is the Fed now going to switch its view from looking at Y/Y numbers to looking at monthly ones (i.e., always choosing the worst view)? We don’t know the answer to that – but our gut feeling is that they have already overtightened policy.

Debt – An Emerging Issue

We see very little written about the growing debt problem, but debt is a growth killer. With aging demographics and labor shortages, growth is already a problem. Debt has risen on household, corporate, and government balance sheets. The savings rate in the U.S.(chart) is down to the 5.0% area, a post-pandemic low, and most of such savings come from the higher income earners. Lower-income families have either cut back or borrowed heavily on their credit cards in order to keep their living standards.

Corporate cash flows are dwindling relative to their liabilities (chart), leaving them little choice but to borrow to expand, postpone any expansion, or, for most, look for ways to cut costs. The latter means lowering labor costs either through shorter hours (the workweek has been contracting), a slower increase in pay/benefits or directly through layoffs (which we expect to see as the Recession unfolds).

The worst trend we see is at the Federal level. Debt there exploded during the 2.5 years since the pandemic – by $7 trillion. The national debt is now $24 trillion; it was $17 trillion in February 2020; that’s a 41% increase in a very short period of time. The gross cost of the debt in August was $88 billion. Because the Fed and other agencies own a significant portion of the debt and return the interest to the Treasury, the net interest expense was $63 billion in August, or $756 billion on an annualized basis. Let’s not forget that the Fed is reducing its balance sheet at a rate of $95 billion/month, of which more than $60 billion is from its Treasury holdings. As a result, the net cost to the Treasury will be rising, even if the federal government runs a balanced budget (fat chance!). As the Recession unfolds, tax revenue is going to fall. Capital gains taxes have averaged about 12% of individual tax revenues; these will dry up in the 2023 tax collection cycle given the losses sustained in both the equity and fixed-income markets this year. Hence, the federal deficit is likely to be quite large in 2023 (and 2024 due to the Recession).

Some economists believe that as long as the economy grows as fast or faster than the debt, the burden of the debt as a percentage of GDP doesn’t grow, so the debt doesn’t become an increasing burden as a percentage of GDP. This, we think, is true to some extent. But the level of interest rates plays a big role here, and, rates today are quite high when viewed against the potential growth rate of an economy with demographic issues (the percentage of older citizens and a low birth rate). Even the most optimistic pundits don’t think the potential growth rate of the economy is greater than 2%. Our view is that it is likely closer to 1%. In the short-run, that is moot, as 2022 and 2023 will likely show negative growth.

The current net annual interest rate on the debt is more than 3% and rising as the Fed has pushed today’s rates to the 4% area. Over the next couple of years, deficits will rise as the Recession and comatose markets reduce the tax take. In addition, the large monthly reduction of Treasuries in the Fed’s balance sheet means the net cost to the Treasury will be rising; it could be over $1 trillion soon (in a $6 trillion budget). That would be more than the annual cost of Social Security.

Debt is a growth killer, especially as interest rates rise because it takes more and more of current income to service that debt. That leaves less for households to consume and for businesses to invest. Rapidly rising household, corporate, and especially government debt hasn’t been written about or discussed much, perhaps because interest rates were so low for so long. Debt, however, is going to be a big issue in the foreseeable future.

Labor Market – Reprise

In our last blog, we discussed some anomalies we saw in the Payroll Employment data. To reiterate, on a non-seasonally adjusted basis (NSA), YTD through August, payrolls have risen +2.2 million, but, seasonally adjusted (SA), that number is +3.5 million. The difference is 1.3 million. Theoretically, over the year, the SA process is supposed to net zero with the NSA data. Seasonal factors adjust for influences within the year itself – like retail sales around the holidays.  So one of two things should happen 1) the seasonal factors will be negative to the tune of 1.2 million payrolls in the September to December period (that’s 300,000/month!) – this is highly unlikely even though it would appear logical, or 2) the past data will get adjusted downward.  For the Payroll data, in particular, the BLS changes the seasonal factors on a monthly basis (the so-called “Concurrent Seasonal Adjustment Method”). They actually make revisions to the data all the way back to January every single month, but they only tell the public the revision for last month. There is a footnote in their monthly release that says they don’t want to “confuse” the public! In January of every year, they make all the revised data public for the entire preceding year, but, by that time, nobody cares to even look!

As we said in our last blog, we are going to see the unemployment rate rise, likely much higher than the Fed’s current 4.4% estimate. Until their September meeting, the Fed had a 3-handle on its unemployment forecast! So, this is their way of telling us there won’t be a “soft landing.”


Housing is the most interest rate-sensitive sector, and we are seeing a Recession in that sector rapidly unfold. For several months, we have noted that the University of Michigan’s Consumer Sentiment sub-index (Buying Conditions For Houses) was at an all-time low (chart).

  • Existing Home Sales fell -0.4% in August, and are down seven months in a row and are now -20% below year-ago levels (chart). The median price is -6% below last March’s peak. The expectation is that the inventory of homes for sale will decline because families with homes that have 3% mortgages won’t be looking to sell and upgrade with 30-year fixed rate mortgages sitting close to 7%.
  • Pending Home Sales (these are new contracts signed) fell -2.0% M/M in August, now down three months in a row and in nine of the last ten. Y/Y they are off -22.5%.
  • Mortgage applications continue to decline with applications to purchase down -29% Y/Y and refinance applications off a whopping -83%. Cash from refis are most often used to finance big-ticket items like buying a car, a home remodel, or even sending junior to college. So the 83% fall-off in refi applications is going to have a large impact on such purchases going forward.
  • Redfin reports that 21% of homes listed for sale dropped their asking price in July. (This wasn’t captured in August’s CPI!)  The Federal Housing Finance Agency (FHFA) has a home price index. It fell by 0.6% in July.
  • The Case Shiller home price index showed its first negative monthly price pattern since 2012 in July (-0.44%). This index was rising more than 2%/month in late winter, and early spring. This is the first decline in the Case-Shiller since March 2019, and the steepest since November 2011. The data points are from July (that is the latest data we have) – it is almost October – we suspect August’s and September’s numbers will show much lower prices.
  • Builders now have bloated inventory and are cutting prices (-6.3% in August) and prices have fallen in 3 of the last 4 months. Still, at a $436K median, prices have a lot of air under them, as the median price in mid-2020 was $370K, before the melt up in prices began.
  • New home sales unexpectedly rose in August to 685K units at an annual rate from 532K in July. Still, YTD sales are down at a -26% annual rate. The reason for the rise was twofold: 1) the price concessions given by the builders, and 2) the slight 50 basis point temporary drop in August in mortgage rates. We believe this is a one month phenomenon as interest rates have reversed.
  • The housing bubble is actually bigger now than it was in 2006-07. That bubble burst because the Fed raised interest rates! (Yikes! Might this be a repeat?) They tightened policy from 2003 to 2006 (but at a much slower pace than today), and, in 2007, that bubble burst. By the way, back then, home prices deflated 25%.


  • A September 27 headline in the Wall Street Journal read: “Rents Drop for First Time in Two Years…”
  • All the Regional Fed Manufacturing Surveys (monthly) are telling the same story about supply chains. The graphs below are from the Richmond Fed as this is the most recent of the regional surveys. Note the rapid falloff in the charts for order backlogs and vendor lead times. This indicates that supply chains are back to normal. New orders, employment, and prices paid and received have also weakened significantly in each Regional Fed Survey.
  • As noted by Chairman Powell at the after-meeting press conference, inflation expectations have remained well-anchored. This is key because expectations play a pivotal role in the inflation process. One of our colleagues, Bob Khoury of Morgan Stanley, who helps us in our fixed-income practice, emailed us the following note on Friday (September 30):

[F]uture inflation expectations, as demonstrated in… [the Treasury Inflation-Protected Securities] market have collapsed. 1-year inflation is priced at 1.81% and that’s down from a March high of 6.30%. 5-year expectations are currently 2.19%, and that’s down from 3.73%. Taming expectations and preventing high inflation from embedding in mindsets are transmitted through this market.

The Shrinking Money Supply

The famous economist, Milton Friedman, taught the economics world the importance of money. If there is too much, we get inflation. If there isn’t enough for companies to borrow to expand, the economy slows. This Fed has embarked on a policy of selling off its portfolio of Treasury and Mortgage-Backed Securities, which it built up over the past decade. This is called Quantitative Tightening or simply QT, and it shrinks the money supply.  Friedman taught us that economic growth + inflation is, in the long run, equal to the growth of the money supply. So, if the economy can potentially grow at 2%, and the Fed wants 2% inflation, then the money supply should grow at 4%. During the Covid episode, the money supply grew at a significant double-digit rate; thus, the high rate of current inflation. Now, on top of rising interest rates, the money supply is shrinking (and M/M inflation is 0%) and it is going to shrink faster going forward as the Fed has told us it will sell larger quantities of securities from its portfolio in the months ahead. Besides the restrictive interest rates, which markets and pundits are fixated on, we also have a shrinking money supply. Every indicator is pointing to a Recession.

Final Thoughts

As is apparent from the incoming data, the economy has entered a Recession; it is still mild, but a Recession nonetheless. The Fed, clearly ignoring the incoming data and concentrating on backward-looking indicators (i.e., the Y/Y rate of inflation and the unemployment rate), has become more hawkish and has now told the market that it intends to raise rates another 125 basis points before the year’s end and even more in 2023. The Summary of Economic Projections (the dot-plot) from which the markets glean the Fed’s intentions, has historically had a 37% correlation with what actually transpires as far as rates are concerned, and it is clear that the FOMC members are nowhere near consensus for 2024 and 2025 rate levels. July’s M/M CPI was -0.1% and August’s was +0.1%. Over those two months, the headline CPI was flat (i.e., 0%).  Seems like the Fed should recognize this, especially since monetary policy impacts the economy with long and variable lags. Yet this Fed is still moving forward with the increasingly restrictive policy, seemingly impervious to the lagged impacts of its prior rate hikes. We are already seeing the impacts of rising rates in the housing market, and we have had two quarters in a row of negative GDP and nearly daily evidence that the economy is weakening/contracting. Ultra-high rates here are also causing chaos in the foreign exchange markets.

Powell has referenced Paul Volcker several times, both in public statements and in his remarks to Congress, holding Volker out as a hero to be emulated. Volker, of course, did slay the inflation dragon, but the cost was two significant recessions in the 1980s. Of greater import, Volker knew that monetary policy acts with long lags because he moved the Fed Funds rate down when the Y/Y inflation metric was still over 11%! The continuance of ever more restrictive monetary policy (including Quantitative Tightening (QT)), which has already pushed the economy into the initial throes of a Recession, will only make that Recession deeper and longer.

                                    Future Y/Y Inflation if M/M Inflation is Tame (0%)

Factors that lead to inflation strongly suggest that the Y/Y trend in the CPI will be sliced below +2% next year. The table shows what the backward-looking Y/Y rate would be, by month, going forward, if the M/M rate of inflation remains at 0% as it has in July and August. By the time the Fed pivots, as it awaits its 2% Y/Y goal, the economy will be in a deep Recession.

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog)


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