Scarcely a day goes by without intense media coverage of the potential fallout from the “housing bubble,” the deleterious impact of past Fed rate hikes, or the lingering effects of still-high energy prices.
But are things really as bad as the experts seem to tell us? My answer is no.
The disposition of real short-term interest rates and credit spreads suggest that financial conditions remain accommodative and that growth should continue at an above-trend pace. Lower tax rates on capital and labor are locked in pace until 2010, a positive for the aggregate supply-side of the economy.
Much has been made of the inverted Treasury yield curve, with short-rates higher than long rates, a historical harbinger of recession. But I believe this has more to do with excess global liquidity and risk aversion — which has unmoored global bond markets from the fundamentals — than real risks to output and employment. Above-trend bank credit growth and tight credit spreads belie the notion that the Fed has lifted the bank rate to a level that will stifle aggregate demand.
This logic is supported by the fact that long-term Treasury yields remain low relative to their historical spread against core inflation, headline inflation, nominal GDP growth, the Fed funds target rate, and the earnings yield on equities. Relatively high gold prices and a relatively weak dollar also suggest that bond yields in current ranges are anomalously low.
Some argue that the bond market simply is sniffing out a housing implosion and broader deflationary pressures that are likely to take shape in its wake. But for now, the sharp cooling in residential real estate looks as if it is being offset by strength in other sectors. Non-residential structures added about as much to headline GDP growth during the second quarter as the residential sector subtracted from it (0.6 percentage points).
Prior to the housing weakness (and recessions) of 1974-75, the early 1980s, and 1990-91, real short-term interest rates (using the core PCE deflator) rose to or above 5 percent. Real rates at this level would require the fed funds rate to rise above 7 percent in today’s core inflation environment, a level that is highly unlikely to be reached by late 2006 or even early 2007. Moreover, the weakness in residential real estate has not lifted mortgage delinquencies or defaults above long-term averages, which means financial stress resulting from the housing slowdown seems to be contained thus far.
The dominant risk in my view remains inflation, not growth. Four years of excess global liquidity and dollar weakness, which first ballooned commodities and housing, now have begun to show up in unit labor costs, which are advancing at the fastest pace since 2000 and 1990 respectively. The difference is that real short rates are lower and financial conditions remain looser than they were during 2000 and before 1990. While some argue that the recent rise in unit labor is only the result of high-end bonus and stock options, this doesn’t explain why the 3.9 percent annual advance in non-supervisory wages is well above both the ten-year average and productivity growth.
This suggests to me that one of three things will occur: The labor market will weaken, reducing unit labor costs; profit margins will sag; or core price pressures will intensify. The first scenario doesn’t make sense with initial jobless claims holding in a tight range just above 300,000, unemployment low by historical standards, and the employment-to-population ratio on the rise. The second scenario is a risk, but only if credit conditions tighten considerably. This is why I believe the last scenario — rising core inflationary pressures — remains the most likely outcome.
In this vein, it is worth noting that the median CPI, which isn’t affected by oil or shelter costs, has advanced at a 4.5 percent annualized pace during the last four months, the fastest four-month pace since the early 1990s.
The Fed, along with many economists on Wall Street, expects weakness in residential real estate to pull growth below trend, boost household caution (increase the so-called savings rate), and thus create “disinflationary slack.” The textbook result is that core inflation will fall back into the Fed’s 1 to 2 percent target zone during the next several quarters. It’s a nice neo-Keynesian syllogism, but an unlikely one.
Financial conditions remain accommodative despite the recent drop in commodity prices. Tax rates on capital and labor have dropped and are locked in place for the next several years. These are powerful pro-growth forces. However, we can’t have our accommodative aggregate demand curve and eat it too: Core inflationary pressures almost surely will continue moving higher during the quarters ahead as a delayed response to excess liquidity and dollar weakness continues to feed through the dollar-price stream.
– Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.