The week of October 17, 2022: Housing and the new interest rate environment, the Fed, student debt, industrial policy and much, much more.
The week of October 17, 2022: Housing and the new interest rate environment, the Fed, student debt, industrial policy and much, much more.
T here are plenty of reasons why Liz Truss failed as Britain’s prime minister — incompetence among them — but one of the errors that brought her down is especially significant, even for those not interested in British politics. That is Truss’s failure to realize that bond vigilantes — woken from their long slumber (primarily) by inflation and the fight that is belatedly being fought against it — are once again on the prowl.
To go over this painful topic again: A mini-budget that might have been largely overlooked by the markets a year or so ago triggered a sell-off in British government bonds (gilts) so severe that the Bank of England had to intervene. Part of the backdrop for that sell-off was a liquidity problem faced by some pension funds holding gilts; in the era of ultra-low interest rates, these funds felt compelled to soup up their returns with the use of derivatives. How else were they going to meet their obligations to actual or prospective pensioners on defined benefit schemes (still a relatively high number in the U.K.)? As yields soared in the aftermath of the mini-budget, gilts plunged, and those on the hook because of their exposure to derivatives faced ever more demanding margin calls. That pressure led to more selling, and a doom loop was born.
This is likely to be first of many debacles. Indeed, ultra-low interest rates tend to invite malinvestment. Sometimes this investment is accepted eagerly, and sometimes it is accepted — as in the case of those British pension fund managers — because the investors feel they have no other choice. Regardless, when the interest rate environment changes, the consequences can be catastrophic.
To quote yet again those words of Warren Buffett:
Only when the tide goes out do you discover who’s been swimming naked.
In earlier comments on this topic, I have expressed concerns over a couple of major European banks, open-ended bond funds, the shadow banking system, lower-rated corporate debt, “alternative” assets, British gilts (see above), and Italian sovereign debt.
But what about housing (which accounts for roughly 15–20 percent of US GDP)?
Ian Harnett, writing in the Financial Times on September 1:
Over the last century, housing has helped define the swings in the economic cycle, being a key driver of investment, employment, and consumption (especially white goods). As one recent research paper put it. “Housing IS the Business Cycle”.
Easy monetary and fiscal policy, post-pandemic, has helped fuel 20 per cent US house price inflation (the fastest seen since December 1946). Three-year house price inflation of 46 per cent in nominal terms and 28 per cent in real terms has only been matched by the bubbles of the early 1980s and mid-2000s in the past 70 years. However, these “good times” for US housing look to be ending…
Over the past decade owning a house has meant easy money. Prices rose reliably for years and then went bizarrely ballistic in the pandemic. Yet today if your wealth is tied up in bricks and mortar it is time to get nervous. House prices are now falling in nine rich economies. The drops in America are small so far, but in the wildest markets they are already dramatic. In condo-crazed Canada homes cost 9% less than they did in February. As inflation and recession stalk the world a deepening correction is likely… Although this will not detonate global banks as in 2007-09, it will intensify the downturn, leave a cohort of people with wrecked finances and start a political storm.
The cause of the crunch is soaring interest rates: in America prospective buyers have been watching, horrified, as the 30-year mortgage rate has hit 6.92%, over twice the level of a year ago and the highest since April 2002. The pandemic mini-bubble was fuelled by rate cuts, stimulus cash and a hunt for more suburban space. Now most of that is going into reverse. Take, for example, someone who a year ago could afford to put $1,800 a month towards a 30-year mortgage. Back then they could have borrowed $420,000. Today the payment is enough for a loan of $280,000: 33% less. From Stockholm to Sydney the buying power of borrowers is collapsing. That makes it harder for new buyers to afford homes, depressing demand, and can squeeze the finances of existing owners who, if they are unlucky, may be forced to sell.
Most of those who bought homes over the past decade did so not out of any speculative motive, but because they simply needed somewhere to live. In 2023, they may look back and think that they overpaid for their home, but from the perspective of, say, 2017, they paid the going rate. The issue is that the going rate had been inflated by ultra-low interest rates. But that rate was affordable because of those same ultra-low rates, and so prices kept rising. Another loop.
In the U.S. some comfort comes from the fact that most mortgages carry fixed rates for relatively long periods. Borrowers will thus continue to benefit from the low rates on the loan they took out a few years ago (which, incidentally, will be strongly negative in the current inflationary climate,). The catch — there’s always a catch — mortgages are not portable. If those borrowers need a new mortgage in the event of a move, it will be much more expensive. That’s a good reason to stay put if they are in a position to do so. This could reduce demand for housing (thus, theoretically, hitting prices), but it could also constrain supply by making people unwilling to sell for a loss (thus, theoretically, keeping prices up). Quite how all that balances out, I don’t know, but a housing market where people are “locked in” their homes is not a particularly healthy one.
All that said, inventories — though still low on a historical basis — have been spiking: Bottoming out at 2 months in January, they are now standing at roughly 4 months.
Under the circumstances, it was no great surprise to read this in the Economist’s report:
Sales of existing homes in America dropped by 20% in August year on year, and Zillow, a housing firm, reports 13% fewer new listings than the seasonal norm. In Canada sales volumes could drop by 40% this year.
Back to the Economist (emphasis added):
The good news is that falling house prices will not cause an epic financial bust in America as they did 15 years ago. The country has fewer risky loans and better-capitalised banks which have not binged on dodgy subprime securities. Uncle Sam now underwrites or securitises two-thirds of new mortgages. The big losers will be taxpayers. Through state insurance schemes they bear the risk of defaults. As rates rise they are exposed to losses via the Federal Reserve, which owns one-quarter of mortgage-backed securities.
Some other places, such as South Korea and the Nordic countries, have seen scarier accelerations in borrowing, with household debt of around 100% of GDP. They could face destabilising losses at their banks or shadow financial firms: Sweden’s central-bank boss has likened this to “sitting on top of a volcano”.
Indeed, it may be time to add South Korea and the Nordic region to the list of worries. Speaking of the latter, it was interesting to read that 80 percent of Swedish mortgages carry fixed rates for two years or less.
China, of course, is an outlier. Their housing-related financial crisis, the world’s worst, is “mercifully, contained within its borders” according to the Economist. That said, recession-worriers will note that this will hit China’s demand for imports.
Some U.S. Datapoints:
Homebuilder sentiment in the single-family home market has fallen to half what it was just six months ago as mortgage rates climb, according to a new report.
The National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index (HMI), which is designed to gauge market conditions, fell 8 points to 38 in October from the previous month.
That’s the lowest level since 2012, with the exception of a brief drop at the start of the coronavirus pandemic. A rating below 50 is considered negative
U.S. home prices cooled in July at the fastest rate in the history of the S&P CoreLogic Case-Shiller Index, according to a report released Tuesday.
Home prices in July were still higher than they were a year ago, but cooled significantly from June gains. Prices nationally rose 15.8% over July 2021, well below the 18.1% increase in the previous month, according to the report.
Month-on-month, the numbers showed a 0.44 percent fall, the first outright decline since 2012.
The Wall Street Journal, October 20:
U.S. existing home sales fell for an eighth straight month in September, the longest streak of declines in 15 years, as the once-booming housing market becomes a bigger drag on the U.S. economy…
The new-home market, which accounts for about 10% of total home sales, is also showing signs of weakness. Housing starts, a measure of U.S. home-building, fell 8.1% in September from August, the Commerce Department said this week. A measure of U.S. home-builder confidence fell for the 10th straight month in October to the lowest level since May 2020, the National Association of Home Builders said this week….
Despite the sharp decline in sales, home prices are rising on a year-over-year basis, in part because supply remains tight. But price growth is slowing from its red-hot pace earlier in the year. The median existing-home price rose 8.4% in September from a year earlier to $384,800, the third straight month of single-digit-percentage increases following 23 months of double-digit-percentage annual price growth, according to NAR [the National Association of Realtors]. Some economists expect prices to post year-over-year declines starting next year.
Prices fell month-over-month for the third straight month after reaching a record high of $413,800 in June, NAR said.
Well, you get the picture.
So, is a U.S. housing crash on the way? Some of these negative numbers are merely a descent to earth after the pandemic-related surge in demand and prices, a fact that will be cold comfort to those who bought during that period. This would probably have been expected even without the Fed hiking rates. I cannot help wondering, however, if the decline in prices now creeping into forecasts – I saw one prediction that prices would fall three percent in 2023, for example – are too modest. A recession would be expected to knock down prices further, and sell-offs can feed on themselves.
The bigger question is whether a larger de-rating of residential real estate reflecting the end of ultra-low rates is on the way. Boldly, I’ll just declare that it’s too soon to say. The answer is further complicated by inflation. If it persists at current levels, or even a more “respectable” 4–5 percent, then real estate may well attract buyers as an inflation hedge as it has in the past.
Meanwhile, The Economist also turns its attention to the (negative) wealth effect created by falling home prices. As the magazine’s writers acknowledge, that may, from the perspective of an inflation-fighting central banker be a feature not a bug. If people feel poorer, they tend to spend less, reducing demand. A similar argument can be (and is) made about falling stock markets, although the latter are likely to come with fewer political consequences.
The Economist:
A generation of young people in the rich world feel they have been unfairly excluded from home ownership. Although lower house prices will reduce the deposit needed to obtain a mortgage, it is first-time buyers who depend most on debt financing, which is now expensive. And a whole new class of financially vulnerable homeowners are about to join the ranks of the discontented.
That is not a reassuring thought.
The Capital Record
We released the latest of our series of podcasts, the Capital Record. Follow the link to see how to subscribe (it’s free!). The Capital Record, which appears weekly, is designed to make use of another medium to deliver Capital Matters’ defense of free markets. Financier and NRI trustee David L. Bahnsen hosts discussions on economics and finance in this National Review Capital Matters podcast, sponsored by the National Review Institute. Episodes feature interviews with the nation’s top business leaders, entrepreneurs, investment professionals, and financial commentators.
In the 89th episode David is joined by Phil Gramm, former long-time senator in the great state of Texas, and author of the brand new book, The Myth of American Inequality: How Government Biases Policy Debate. This is a powerful dialogue about the key economic issues of our time and the movement to keep American prosperity robust and opportunity mobile. Come for the accurate math, stay for the takeaways!
The Capital Matters’ week that was . . .
Banking Secrecy
For further evidence of the U.S. government’s embrace of a culture of financial surveillance and control, one need only look at recent cryptocurrency reports written by the Department of the Treasury and the Department of Justice…
The Fed
The Federal Reserve is tasked with conducting monetary policy in accordance with a dual mandate of maximum employment and stable prices. The Fed has traditionally used these goals as guidelines to help improve economic stability.
Under pressure to implement diversity, equity, and inclusion (DEI) initiatives, however, the Fed revised its monetary-policy objectives to make its employment target more “inclusive.” Pursuit of this goal was one reason that the Fed maintained an overly expansionary policy, with consequences of which we have only just been reminded…
Macroeconomists are often depicted as being constantly at odds with one another. There’s some truth to that, and many key questions about business cycles lack agreed-upon answers. But there are many cases where macroeconomists do actually agree on a position that’s based on evidence and research. Monetary policy’s not being a good tool to fix inequality is one such case.
was more a reflection of political factors than economic ones. It’s not as though there was a big debate among Fed economists, with some saying that monetary policy is good at fighting inequality and others saying it’s not, and the DEI proponents won the argument. No such argument happened. They pretty much all agree that monetary policy is no good at addressing inequality.
Instead, the internal debate probably went something along the lines of: What do we have to do to stay in the good graces of Congress and adjust to the political reality of our time?…
Transportation
In a rare moment of energy clarity, the Biden administration ruled out a ban on natural-gas exports this winter, which would have resulted in less supply in global energy markets to meet growing demand, subsequently inflating prices back home. This is welcome news, but more can and should be done to reduce prices for consumers. Repealing the Jones Act would be a great place to start…
Sometimes, life is weirder than fiction. Such is the case with this Dispatch story that explains how a set of FOIA’d documents from the Maritime Administration contained a sentence on how Mercatus colleagues of mine past and present, the entire staff of the Cato Institute, and I should be charged with treason for criticizing the Jones Act…
Climate Policy
We’re often told about all the jobs that the race to net zero (greenhouse-gas emissions) is going to generate. That has never seemed particularly plausible to me, especially if looked at after taking account of all the jobs that are going to be lost, either directly or indirectly, through decarbonization. But even the gross total of jobs created will, I suspect, disappoint.
This report in the Financial Times therefore has done nothing to make me think my suspicions are incorrect…
Not only are electric vehicles (EVs) considerably less friendly to the environment than those who would like to compel us to buy them admit, but also one of their key components relies, at least in many cases, on child labor…
The “politicians decided dogmatically.” They decided voters want electric vehicles (EVs), which, presumably is why they felt it necessary to ban alternatives, in case, presumably, voters did not want EVs, you know, quite enough.
Central planning is what it is.
International
The International Monetary Fund (IMF) has long presided over the world’s heavily indebted lower-income countries (LICs) as a hybrid bankruptcy court and controlling lender. Under its aegis, an endless series of sovereign-debt restructurings have taken place, negotiated within the parameters of an IMF debt-sustainability analysis, IMF technical assistance, and an IMF standby agreement. Meanwhile, China’s Belt and Road Initiative (BRI) has propelled China into a leading position among the world’s official creditors, surpassing all members of the Paris Club and challenging the IMF’s central position. China has made more than $800 billion available via the BRI for infrastructure projects in Asia, Africa, Europe, and Latin America since 2013…
By now, it is clear that British prime minister Liz Truss is, in the famous phrase, in office but not in power. She has sacked her close political ally and good friend Kwasi Kwarteng as chancellor of the exchequer after a record-breaking short period in office (only a chancellor who died after 30 days lasted for a shorter period) and replaced him with a “safe pair of hands,” Jeremy Hunt. Hunt has proceeded to rip up all of Kwarteng’s economic plans and provide an alternative vision that has calmed the markets but reduced Truss’s power more. Her Conservative Party is facing electoral oblivion, her personal unpopularity is unprecedented, and her days in 10 Downing Street may well be numbered — but who would want to replace her?…
“Under Mr. Xi’s leadership, China is returning to its roots: a state-controlled economy that demands businesses conform to the aims of the Chinese Communist Party.”
So says a recent article by Daisuke Wakabayashi, Chang Che, and Claire Fu in the New York Times. As Xi Jinping begins his third term as China’s paramount leader, it’s worth thinking about whether the economy he increasingly commands will be able to adjust to changing circumstances and continue to grow as it has in the past…
Unfortunately, the narrative that irresponsible “free-market fundamentalism” (rather than a series of blunders) plunged the U.K. into a crisis has been taken up with gusto by much of the media, the opposition, and a notable section of the parliamentary Conservative Party. Whoever emerges as their new prime minister, the likelihood is that the Tories will consign supply-side reform and, in due course, themselves to the recycling bin (if not the trash can) of history.
Regulation
The baby-formula shortage that captured national attention over the summer is still ongoing, despite the Biden administration’s actions aimed at alleviating it. Nearly a year after the first rumblings of a shortage began, families are still having a hard time finding formula. How families are dealing with it has become a question on official government surveys…
San Francisco is building one public toilet, to be completed in 2025 at a cost of $1.7 million, and politicians there today held a press conference about it. The process that led to this pricey potty is a pretty good summary of everything wrong with San Francisco’s regulatory environment, the function of which is to make it nearly impossible to build anything.
A statement about the project from the city said that “while this isn’t the cheapest way to build, it reflects San Francisco’s values.”
The Biden administration is not known for its light-handed regulatory touch, and so we should not be surprised that its efforts have included unhelpful initiatives targeting nearly every major household appliance. Perhaps worst of all for homeowners are the proposed regulations for new natural-gas furnaces…
Student Debt
Finally, we need to understand the sheer cost of cancellation. Exactly how expensive it will be is uncertain — it depends on how many people apply, how many would have used other forgiveness programs, and more — but estimates range from the administration’s figure of about $380 billion, to the Congressional Budget Office’s estimate of $430 billion, to the Penn Wharton estimate of up to $520 billion.
To put those numbers in perspective, they are roughly equivalent to the gross domestic products of Iraq, Hong Kong, and Sweden, respectively…
Central Bank Digital Currencies
When asked his opinion on a restaurant, former baseball player and manager Yogi Berra infamously replied, “Nobody goes there anymore. It’s too crowded.” When it comes to central-bank digital currencies (CBDCs), much of the debate reads in a similar way: CBDCs are going to be so great, nobody will use them…
Energy
In his remarks today about the cost of gasoline, President Biden said, “The price at the pump should reflect what the price of a barrel of oil costs, and it’s not going down consistently.”
This is part of a continued effort by the White House to blame corporate greed — rather than government policies — for inflation. That’s little more than a conspiracy theory. If the White House has some evidence that corporations are working together to keep gasoline prices high, it should reveal it. It’d be a global scandal, and deservedly so…
Meanwhile, Qatar’s energy minister warns (and this should not be news) that getting through the winter of 2022/23 will not be the end of Europe’s problems…
Fiscal Policy
One of the many criticisms of the Biden administration’s proposal to waive college debt is that it creates the moral hazard of encouraging increased student borrowing in anticipation of future debt relief. But such moral risk isn’t exclusive to students. Some of the nation’s largest — and bluest — states now appear to be holding out for similar relief from tens of billions of dollars in federal unemployment loans that they accepted during the pandemic. If granted, this would only encourage greater state dependence on federal loans — and ultimately on federal taxpayers…
CNN contributor John Kasich, in a Wall Street Journal op-ed earlier this week, lectured soon-to-be-former British prime minister Liz Truss on sticking to her fiscally conservative principles. It’s wise advice that Kasich himself ignored while governor of Ohio.
“My team and I got the state’s fiscal house in order with a conservative approach to managing taxpayers’ money and a tight rein on government spending,” Kasich, a Republican, wrote of his eight years as governor (2011–19)…
Labor
President Biden claims that competitiveness is one of his top priorities in economic policy, but when the interests of organized labor contradict competitiveness, he sides with organized labor. We’ve seen it with his support for the Jones Act, which guarantees an uncompetitive domestic-shipping industry by design but has strong union support. It’s the same story with independent contractors. The gig economy has injected competition into countless sectors over the past decade, but if restricting it makes unions happy, Biden is for restricting it…
The Department of Labor (DOL) announced last week that it was proposing a new rule to prevent “worker misclassification.” This is the latest volley in an ongoing battle by federal regulators and organized labor meant to bring so-called “gig economy” companies to heel, with millions of freelancers caught in the middle…
Industrial Policy
Industrial policy involves trying to alter the allocation of resources and incentives in particular economic sectors that would otherwise transpire if entrepreneurs and businesses were left to themselves. The goal is to produce better results in that economic sector. Efficiently realizing such goals assumes, however, that political leaders, civil servants, and technocrats possess the knowledge to comprehend all the technical details, possible methods of production, the range of incentives, actual and future prices, unintended consequences, and alternative uses of resources (to name just a few sets of information) that they would need to decide accurately the most optimal allocation of resources and course of action.
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