First American

The REconomy Podcast™: Has the Federal Reserve’s Fight Against Inflation Peaked?

In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi break down the Federal Reserve’s efforts to rein in inflation by raising the federal funds rate and tightening monetary policy and whether or not the Fed’s rate increases have peaked.

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Listen to the REconomy Podcast Episode 51:

“Inflation seems to be in all indication in the near future beginning to come down dramatically. And the goal of the Fed's monetary tightening is to cool demand and bring prices under control. And, in some very interest-rate sensitive sectors, such as housing, that policy clearly seems to be working. The housing market is quickly cooling from the red-hot pace of the past two years. But, in other corners of the economy, especially the labor market, the Fed is not yet seeing that same cooling, and that's really what the problem is.” – Mark Fleming, chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 51 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark. On today's episode, we have to talk about the Federal Reserve's sixth consecutive rate hike.

Mark Fleming - Hi, Odeta. It is absolutely a must. And I think that's probably because it's top of mind for practically everyone at the moment. And it's not just that the November rate hike was the sixth consecutive rate hike in a row, but that it was the fourth consecutive 75-basis point hike and that's huge, possibly unprecedented in recent rate-hiking history.

Odeta Kushi - Yeah, it brings the short-term borrowing rate target range to 3.75 to 4%, the highest level since January 2008. It's also the most aggressive pace of monetary policy tightening since the early 1980s.

Mark Fleming - That makes sense. Since that was the last time we saw inflation get this hot. In the modified words of Mark Twain, quote, economic history doesn't repeat itself, but it often rhymes.

Odeta Kushi - So, if this period is similar to or rhymes with the 1980s, can we expect the federal funds rate to reach 19%? As it did at the height of Fed tightening in the 1980s?

Mark Fleming - Wait, hold up? Is this the Halloween episode? Because that would be downright scary. Absolutely. Since this is not an economic repeat of the early 1980s, because it only rhymes and isn't exactly the same. It likely won't get to those levels. But we can certainly expect rates to move a little higher still. Just look at the terminal rate.

Odeta Kushi - The terminal rate?

Mark Fleming - Yes, you know, one of those other esoteric economic concepts that's really hard to measure in the real world. It's the level at which the Fed is expected to stop raising rates. But since it's not easily measured, what can we do?

Odeta Kushi - I suspect you are asking rhetorically.

Mark Fleming - Indeed, I am. When in economic doubt, look to the wisdom of the crowds. After the November FOMC meeting, in the futures market, traders bet the terminal rate for the fed funds would reach 5.09% -- yes, two significant digits there -- by the end of May from just over 5% before this meeting, so they're shifting further for a higher terminal rate.

Odeta Kushi - Well, not just that. Chairman Powell himself, in the press conference, said quote the incoming data since our last meeting suggests the terminal rate of the fed funds will be higher than the Fed previously expected, which by the way was 4.63%. And we will stay the course until the job is done. So likely more rate hikes to come. But there is reason to believe that future rate hikes may be smaller.

Mark Fleming - Yes, that comes from the Fed's revised statement.

Odeta Kushi - Yes, economists and analysts everywhere wait patiently for the FOMC announcement and then scrutinize the text to see how it's changed since the last statement. We are a fun bunch, economists.

Mark Fleming - Yeah, let me just clarify for our listeners here. We economists literally track the changes, you know, like the track changes in Word, word by word between the last statement and the latest statement. Fun bunch, indeed.

Odeta Kushi - Yes, definitely invite us to your parties, but we digress. Basically, we're trying to tease out if the Fed is coming across as more hawkish or dovish, and the statement in November kind-of-ish came across as more dovish. The FOMC statement in November changed in one key way. The Fed signaled more increases, but hinted at possibly smaller increments. Shortly after the FOMC announcement, the yield on the 10-year U.S. Treasury note moved below 4%. As investors initially interpreted the Fed's comments that rates might not rise as fast as they have been. However, after Jerome Powell's live press conference came across as more hawkish, yields on the 10-year Treasury increased once more.

Mark Fleming - I really feel like Jerome did the classic, on-the-one-hand announcement and on-the-other press conference to us. But, after all that, I still did see a bit of a silver lining in the FOMC statement, at least for the housing market.

Odeta Kushi - Ever the optimist. What did you see?

Mark Fleming - Well, it was a small one, albeit one there, nonetheless. The silver lining for the housing market is that the Fed is laying out a possible rationale for a slowdown in rate increases. Since economic data is lagging, next year's inflation indicators will likely show a noticeable moderation in some parts of the economy. We'll get to what those are in a minute. Slowing inflation, slowing fed funds increases, less upward pressure on mortgage rates, which could begin to have a stabilizing effect on next year's housing market.

Odeta Kushi - Okay, so let's talk about that inflation. We've seen some evidence that at least goods inflation is slowing.

Mark Fleming - Right. Goods inflation, due largely to COVID-related supply disruptions in combination with COVID-related demand surges for those for goods relative to services, which drove that initial surge of overall inflation. That's moderated in recent months and is likely to slow further. Reasons include a post-COVID shift away from consumer demand for goods, back to those services we missed so much in the pandemic, as well as rising inventories at some retailers and, most importantly, those improving supply chains, finally.

Odeta Kushi - And we also know that shelter inflation lags observed rental and house price increases in both indices, the CPI and the CPE. Sorry, the PCE. So the deceleration we're seeing in house price growth and rental appreciation will start to show up next year and put downward pressure on inflation too. And recall that shelter has a high weight in the CPI and in the Fed's preferred PCE -- 33% in the former and 16% in the latter. So, in both, shelter is a big overall driver. So why isn't the Fed pulling back, if we can expect inflation to moderate next year, in part thanks to decelerating shelter inflation?

Mark Fleming - Right, this is all good news. Inflation seems to be in all indication in the near future beginning to come down dramatically. And the goal of the Fed's monetary tightening is to cool demand and bring prices under control. And, in some very interest-rate sensitive sectors, such as housing, that policy clearly seems to be working. The housing market is quickly cooling from the red-hot pace of the past two years. But, in other corners of the economy, especially the labor market, the Fed is not yet seeing that same cooling, and that's really what the problem is.

Odeta Kushi - So, to your earlier point, there is clear evidence of a housing market slowdown - from mortgage applications to housing starts and home sales. Both new- and existing-home sales are falling. Builders have cut back production in response to rapidly declining affordability, and annual house price growth has slowed from the peak of nearly 21% in March of this year to 15% in August, according to data from First American Data & Analytics. The housing industry, as you mentioned, is highly rate sensitive, making it a primary transmission mechanism for the Fed's monetary policy. Yet, despite the Fed's aggressive monetary tightening, the labor market has proven resilient so far.

Mark Fleming - It's kind of strange to say that a great labor market is bad news for the Fed, but in the inflation fight, this is the way. Get it? This is the way. No? Star Wars. No?

Odeta Kushi - I've never watched Star Wars. I know. That's the reaction, I think I got like a collective sigh of disappointment from all of our listeners, but I have it on my watch list, eventually.

Mark Fleming - Now, you can say it's required for economic purposes to watch.

Odeta Kushi - My boss told me to.

Mark Fleming - Exactly.

Odeta Kushi - All right, again, we digress. But, it seems that is exactly how the Fed feels, right? That we have this tight labor market, but it's not necessarily good news for inflation. We received September JOLTS data earlier this month and what we found is that the number of job openings in September increased by just over 4%, compared to the previous month, to 10.7 million job openings, while hires actually edged down, and the ratio of job openings per unemployed worker increased in September. So, not exactly what the Fed wants to see. Typically, I would say oh good, more jobs available, but not in this case. Job openings outpaced hires by 4.6 million, which is up from last month. So, a tight labor market, not exactly what the Fed wants to see right now. But the reason this gap matters is because a labor market where labor demand outpaces labor supply impacts wages.

Mark Fleming - That's right. And because what the Fed is most afraid of is inflation becoming entrenched, which can occur via a wage-price spiral. This occurs when workers demand higher wages to keep up with rising living costs and, in turn, businesses raise their prices to offset their rising wage costs, leading to a self-reinforcing loop of wage and price increases.

Odeta Kushi - But we're seeing that household spending remains strong despite price increases on essentials, like food. Real personal spending grew faster than personal income in September, indicating that households are drawing down savings accumulated over the past two years to finance spending. And that spending, by the way, is shifting away from goods -- that's your Pelotons, you know, that we all bought over the pandemic -- to services, that's your spending on restaurants and hotels.

Mark Fleming - That's right, but I want to take a side note here, because I always have to bring it back to housing. High inflation and rising interest rates may certainly hurt household budgets because it takes more to buy the same amount of goods. But roughly two-thirds of American households have a great inflation hedge when it comes to their biggest monthly expenditure, housing. Many homeowners locked in a sub-3% mortgage rate on a 30-year -- here's the key thing -- fixed-rate loan, keeping the bulk of their housing expenditures flat, relatively unchanged. Combined with a strong labor market, consumers are feeling confident enough to continue spending because their largest expense isn't changing based upon inflation.

Odeta Kushi - Right. And, by the way listener, that two-thirds number comes from the homeownership rate, right? The homeownership rate is 66%. So, those Americans, a lot of those have a fixed-rate mortgage. So, this is not what the Fed wants to see, this continued spending because, again, they want demand to pull back. The Fed wants people to stop spending so much on services, because all that demand is putting pressure on the economic sector that does not have enough labor to meet all that demand. Hence, higher wages. And services is a very labor-intensive industry. The services sector consists of over 131 million workers and equals 86% of total non-farm employment. In order to slow services inflation, we need to see wage growth slow in the sector. And, speaking of services, when it comes to leisure and hospitality, I mean, have you been to a hotel recently?

Mark Fleming - Yes, and talk about shrink-flation. You know, shrink-flation, the process of items or services reducing quality, while their prices remain the same or increase. I mean, how often do you get your room cleaned these days? How many people are helping you out at the front desk, even though the price of the room has gone up? Hotels seem to cost more, but we're getting less.

Odeta Kushi - I have definitely noticed that, yes. And, in order to attract and retain the workers in those hotels, wages have had to rise. Annual hourly earnings for leisure and hospitality workers are up nearly 8% as of September, which is slower than the peak annual pace of over 13% in December of 2021, but still very, very high. So, as wages rise, then the hotels raise prices, and so on, and so on. So, the Fed will likely be watching for sustained data-driven signs of cooling in the labor market, and specifically wage growth, before it considers easing the pace of rate hikes. But, just one more question. And I have to bring it back to housing again. We talked about this a little bit a moment ago, but I want to return to it. Why hasn't the housing slowdown prompted a pullback in consumer demand?

Mark Fleming - Well, housing does have large multiplier effect on the economy. Higher mortgage rates reduce demand, that's true, prompting home sales to fall. Plenty of evidence of that. Homebuilder confidence and production falls. Plenty of evidence of that. And demand for commodities and lumber and steel -- those inputs into building new homes -- those fall, as well as durable goods, refrigerators, windows, home improvement. Everything that you do when you buy a home, those have all fallen. But those economic contractions spread through the rest of the economy and, in theory, help to tame inflation. But the U.S. is unlike other countries that are more likely to use shorter term, adjustable-rate mortgages that essentially force the borrowers to refinance into higher rate mortgages more quickly. Higher rates, higher monthly allocation of the budget to housing, less to spend in the rest of your budget, so that transmission will happen in places like England and Canada and Australia much faster. The transmission effect of monetary policy through housing is faster in those other countries. But, here consumers are not pulling back spending because of an expectation of higher housing costs in the near future because homeowners can essentially wait out that higher rate environment for as much as 30 years with the ultra-low, 30-year, fixed-rate mortgage that everybody has. Transmission mechanism muted.

Odeta Kushi - Yes, all thanks to that fixed-rate mortgage. That's a really good point. Thanks, Mark. So, to sum up today's episode, while there is reason to believe that inflation will moderate in 2023, the Fed needs to see wage growth, particularly in the services sector, slow because higher wages could point to more entrenched inflation, and the scariest thing of all is a wage-inflation spiral. All right. Well, that's it for today. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

This transcript has been edited for clarity.