When it comes to making important and difficult decisions, it often comes down to the lesser of two evils. Think about it, if you are tight on money, and you need new tires, you have to decide on what you’ll give up to get the new tires or if you can do without the car. If your kid needs braces and you don’t have the money, it’s bag lunch or your kid’s a snaggletooth. This is where the Federal Reserve sits right now.
Inflation is running too high at over 8%, so to combat this the Fed has embarked on the most aggressive rate raising path in history; driving us into a housing correction and a recession. The Fed is doing what many of us would do and look to past experience as a guide on the best way forward but is that the right approach? In this case they’re following 1970’s and 80’s Paul Volker and radically pushing up interest rates. Never before have rates doubled in less than a year, let alone half a year. Unfortunately, this approach has come at the immediate expense of the mortgage business where massive layoffs have commenced in earnest. Let’s not kid ourselves however, this is no accident. The Fed sees the exponential increase in housing costs since the pandemic, both purchase and rental, as a core driver of today’s excessive inflation. But is it? It may be a contributing factor, but it’s not the whole enchilada by any means. None the less, The Fed figures if they can slow housing, they slow the economy which reduces demand and takes pressure off prices, reversing inflation. Home prices are coming down, many in the 8.5-10% range so far (Search for homes here) and this is not a bad thing, per se. Most recent sellers aren’t selling, had sizable down payment cushions, and locked in amazing interest rates. In fact, a housing correction was always inevitable, the market is never static. Lower home prices allow more people to get into the market as affordability improves, that is, provided interest rates are stable. Herein lies the problem. The Fed raised rates so quickly, the system is in shock. This is not a good thing. Today it was reported that home sales dropped to the lowest level since 2010, the pit of the Great Recession. I’m sorry, but that’s a problem. The saving grace here is that sellers aren’t selling en masse, keeping supply of available homes tight which is supporting home values. Whether a full blown recession is in the offing or just some navigated soft landing, only time will tell. (Follow Tim Here). Of course, this begs the question, will their Paul Volker approach work today?
I’m here to argue it will not. A housing correction is one thing, crushing housing is something much different. Moreover, deliberately driving unemployment up is down right, playing with fire. This is what the Fed appears to be willing to do. Currently unemployment is around 3.5% and continuing claims for unemployment are around 1.3M. They’ve implied they want 5% unemployment which means continuing claims around 2M. They’d rather have 2 million Americans out of work and on subsidies than inflation. This is a terrible idea and if you ask someone if they would rather have a job than have to pay more at the pump or grocery store, I’m pretty sure they’d say, “I want to work.”
At this point, the Fed needs to pause. And what if the Fed took a more cautious approach? What if they waited just a bit to see what effect their 3 successive .75% rate increases do to the economy before raising again? These rate hikes haven’t even shown up in the economy beyond mortgage and real estate. And since they’ve raised rates .75% 3 times in 3 months and apparently are poised to do so again in November, it only seems prudent they be more measured. I mean isn’t that what you’d do? Take action and wait to see if it delivers the desired effect? The Federal Reserve governors are supposed to be the smartest guys in the room. They didn’t really think they’d raise rates and then see an immediate drop in inflation to their target level did they? It takes 6-9 months for the higher rates to make their presence known in the economy. The lack of common sense suggests The Fed is panicking.
Here’s the problem as I see it, The Fed was late to reduce the rates and stop their bond buying, holding rates down for too long and now they are trying to make up for lost time. Okay, so mistakes happen, but driving us into a recession in my opinion, is a bad idea anytime. But do they have another choice? As with Maggie and her kid’s braces or Bill with his tires, of course they have a choice. In The Fed’s case, the alternate choice is to let inflation run hot. “That’s a terrible idea,” some will scream. But is it really? To answer this, you need to ask yourself, does demand alone cause inflation? I mean, after all, that’s all the Fed is doing by raising rates, clamping down on demand. By definition, inflation is too many dollars chasing too few goods. Prices go up in response to scarcity. As demand wanes, supply in theory goes up, but the supply doesn’t go up any more than the relative level of decline in demand. Imagine taking a weight off one side of the scale, the other side goes up by the relative change. The Fed itself has no influence on the larger issues affecting supply like supply chain disruption coming from the pandemic or the rise in energy costs as a result of the war in Europe. Even if demand went to near zero, the supply issues would continue. It’s my opinion that pushing us into recession will not be enough to slow inflation to the 2% rate that the Fed states is their target.
On the contrary, I’d suggest they cannot get there until such time as the war with Russia is over and China stops their zero Covid policy and the supply chain heals. In other words, they don’t influence energy costs nor product availability and frankly, as energy goes, so goes inflation. Therefore, pushing us into recession while inflation is still hot, will I believe, lead to the worst possible scenario. Inflation + recession = stagflation. Stagflation is combining a bad economy with inflation and almost impossible to remedy without substantial pain. This is what confronted Volker in the 70’s and 80’s when we were in a recession while facing high inflation. Inflation, I will add, that was largely caused by an energy crisis, sound familiar? What’s different now is that our economy is strong and unemployment low. As long as we stay out of recession, we can avoid stagflation. By the way, owning a home is arguably the best place to be should stagflation really come to pass. A stable payment, a roof over your head and paying down a mortgage. (Find out what your homes worth).
If you accept my premise, the question we and The Fed must ask is, of the two evils we are left with: inflation or recession, which is the lesser evil? I’d argue that recession is never the right answer and that until the supply side issues get resolved, it’s better to live with some inflation.