It's important to recognize that 2009-2019’s economic recovery could not shoulder a 2.38% fed funds rate for long. Nevertheless, many place the neutral fed funds rate at a higher 2.5%, where the neutral rate neither helps nor hinders economic activity.
Thus, the FOMC’s median forecast of a 4.4% fed funds rate by year-end 2022 is far enough above neutral to trigger a recession. And if the recession slashes inflation risks, the 10-year Treasury yield will quickly drop well under 3%.
Rent’s upward bias to future inflation will be recognized
Successful monetary policy is always forward looking. An effective policymaker must be skillful at divining trends. Information only matters if it supplies useful guidance about the future.
To do so, policymakers must understand the degree to which data reflect conditions that have already passed or are nonrecurring.
Nearly 40% of the core CPI consists of either renters’ rent or owners’ equivalent rent. Because rents change only when new leases take effect, the CPI’s rent component is slow to respond to the changes in market conditions that influence rents.
When CPI inflation trends lower, CPI inflation excluding rent (or shelter costs) slows by more than the overall CPI, where the opposite holds true when CPI inflation trends higher.
Regarding the latter, from May 2020's bottom to June 2022's top, the annual rates of inflation rose by a greater 11.8 percentage points for the CPI ex shelter costs (from -1.1% to 10.8%) compared to the headline CPI's 8.9-point increase (from 0.1% to 9.1%).
After understating the underlying inflation rate on the way up, the CPI is likely to overstate inflation’s trend on the way down.
Policymakers will note the upward bias applied to a declining rate of CPI inflation by rent inflation if the macro backdrop favors a declining trend for consumer price inflation. Thus, once the Fed senses the labor market has softened by enough to extend disinflation, rate hikes will end even if CPI inflation still materially exceeds the Fed’s targeted rate.
Higher yields in a declining economy are poison
Treasury bond yields now rise in response to an extraordinary push from Fed rate hikes and the Fed’s reduced holdings of Treasury securities. Fed policy now strives to reduce spending via higher short- and long-term interest rates, where the upward pressure on long-term interest rates also receives support from the shedding of agency mortgage-backed bonds from the Fed’s balance sheet.
The Fed-driven ascent by Treasury bond yields amid a flat economy has worsened the economic outlook. In response to now elevated recession risks, the borrowing costs facing private-sector borrowers have increased by more than the jump in benchmark Treasury yields.
The Fed-driven ascent by Treasury bond yields amid a flat economy has worsened the economic outlook. In response to now elevated recession risks, the borrowing costs facing private-sector borrowers have increased by more than the jump in benchmark Treasury yields.
For example, the 3.74 percentage point increase by the recent 6.70% FHLMC 30-year mortgage yield from 2021’s yearlong average of 2.96% was far greater than the comparably measured 2.45-point increase by the benchmark 10-year Treasury yield from 2021’s 1.45% to a recent 3.9%.
The yield gap between the 30-year mortgage yield and the benchmark Treasury yield has broadened from a 2021 average of 1.51 percentage points to a recent 2.80 points. By contrast, under 2019’s more normal conditions the spread averaged 1.79 percentage points.
Not since July 2007 has the 30-year mortgage yield been as high as 6.70%. Because of today’s costliest mortgage yields in 15 years, not only are mortgage applications from potential homebuyers down by 30% from a year earlier but applications for mortgage refinancings plunged by an even deeper 83% yearly.
When the Fed tightens amid a flat to lower economy, household and business borrowers incur the one-two punch of costlier benchmark Treasury yields and a wider interest rate spread over Treasury yields as compensation for greater debt repayment risks. This supercharged jump by private sector borrowing costs does more than making matters worse for business activity. It also reduces the market value of financial and real assets.
--John Lonski
As Thru the Cycle President, I’m a sought-after expert on the U.S. and global economy. I’ve been a keynote speaker at financial market conferences around the world and my comments have appeared in all major financial press and media outlets. Prior to forming Thru the Cycle, I held the position of Managing Director and Chief Capital Markets Economist of Moody's Analytics.
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