The median forecast by Federal Open Market Committee members after their most recent meeting on June 11 - 12 was just one rate cut during the rest of 2024. This compares with the median expectation of three cuts at the March meeting. Despite the disappointment for investors hoping for rapid Fed easing, yields have fallen across the curve following encouraging inflation numbers published on June 12. The consumer price index was flat in May from April, and rose by 3.3% over the preceding twelve-month period slowing from a 3.4% rise during the year ending in April.
There were other signs of economic weakness that, just a few months ago, would have given rise to calls for rate cuts by members of the FOMC. Here are a couple of data points that stand out. We learned from the US Census Bureau Thursday that housing starts were weak in the case of both multi-family and single-family housing prompted largely by the high cost of borrowing. Housing starts authorized by building permits stood at 1.386 million in May, down 9.5% from the 1.532 million recorded in May 2023. On the consumer front, retail sales rose by a weak 0.1% last month compared with estimates of a 0.2 - 0.3% increase. This after past months’ numbers had been revised downward.
In contrast to their past behavior, Fed Chairman Jerome Powell and his senior colleagues remained cautious in making interest rate projections after receiving these pieces of information. In the case of Powell, there was no repeat of his insistence in December that “We believe that we are likely at or near the peak rate for this cycle.” Nor did he suggest that the FOMC had shifted from how much to increase rates to discussing when, and by how much, to cut them.
The reason behind the Fed’s caution is hidden in the components of the inflation numbers. A major contribution to overall inflation came from shelter which rose month-on-month by 0.4% for the fourth month in a row. The increase in shelter cost was 5.4% over the past year. The rapid increase is a result of surging home prices that is lowering housing affordability for first-time buyers and keeping them in the rental market. Rents being a significant part of the consumer price index will mean that overall prices will keep rising at a pace faster than the 2% that the Fed is targeting.
Second, rapid inflation has moved from goods to services. According to the US Bureau of Labor Statistics, “commodities less food and energy” actually fell in price by 1.7% during the twelve months ending in May. By comparison, “services other than energy services” rose by 5.3%, more than twice the Fed target for the overall inflation rate. Within this component, transportation services surged by 10.5% as residents took advantage of post-covid travel opportunities.
Clients often ask why elevated inflation persists despite the Federal Funds rate having been raised from near zero in March 2022 to a 5.25 - 5.50% range in July 2023 where it still stands. Why has such a rapid move to tighten policy not done enough to arrest the current phase of whack-a-mole inflation eruptions across the economic landscape?
To focus just on the recent monetary tightening would be short-sighted. If, instead, we start the clock in March 2020, the balance sheet of the central bank increased from about $4 trillion to a peak of almost $9 trillion in just two years as the Fed binged on purchases of Treasurys and mortgage-backed securities (MBS). Fed’s purchase of MBS, pushing their yields down, was a key factor in the post-covid surge in home prices.
The Treasurys and MBS were paid for with newly minted cash that added to the liquidity in the system. Although the Federal Reserve started the process of putting the bonds back into the market (aka Quantitative Tightening) some two years ago, central bank assets still amount to $7.3 trillion as of June 12.
In this context, it is useful to keep in mind that the Fed balance sheet totaled only around $800 billion at the time of the Lehman Brothers failure in September 2008. While Fed assets have increased by 800% since then, nominal US gross domestic product is only two times its level 15 years ago! And since covid began in early 2020, the monetary expansion was supplemented by a massive fiscal stimulus program. While an increase in the US government deficit following the brief economic slump during the pandemic is understandable, the shortfall has continued to increase despite the economic recovery. No surprise that inflation is raging despite the increase in interest rates during 2022 - 2023.
These may be some of the reasons why none of those on the FOMC who have spoken in public since the “quiet period” ended on June 13 has suggested an imminent easing of policy. Whether this stance will persist, especially if the elevated interest rates lead to a “credit event,” is the key question. You know my view on this from past reports!
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
June 22, 2024
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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