The week of April 8, 2024: The Fed’s dilemma(s), deindustrialization, student loans, and much, much more.
The week of April 8, 2024: The Fed’s dilemma(s), deindustrialization, student loans, and much, much more.
Not only did inflation move up last month, but it also moved up by more than expected. Hopes that the Fed was poised to cut rates have been put on hold for now. Writing for Capital Matters on Wednesday with Cale Clingenpeel, Kevin Hassett, long skeptical that inflation was on a glidepath to 2 percent, looked yet again at the historical record and warned that “price inflation does not drop below wage inflation, so it stays high until the Fed really tightens.”
Really tightens. That suggests that Kevin and Cale believe that rates are not yet high enough. I asked Kevin about that. In his view, getting real interest rates into contractionary territory would take about one percentage point of hikes. Former Treasury Secretary Larry Summers doesn’t seem so far removed from that, telling Bloomberg that “you have to take seriously the possibility that the next rate move will be upwards rather than downwards,” a possibility that he puts at the 15-25 percent range. Summers drew attention to the acceleration in the supercore services gauge, a measure that excludes food and energy as well as shelter costs.
And so did Hassett and Clingenpeel:
The culprit lies in the wage-sensitive supercore-services sector. The average contribution of supercore services to monthly growth in core CPI nearly doubled from the final three months of 2023 (0.11 of a percentage point) to the first three months of 2024 (0.2 of a percentage point). This acceleration dispels the claim cited frequently late last year that core inflation remained largely supported by housing services, and so the easing in inflation was more or less inevitable in the first half of the year.
In Summers’s view a rate cut in June “would be a dangerous and egregious error.” He believes, Bloomberg reports, that the odds still do favor a Fed rate cut this year, “but not as much as is priced into markets.” Unsurprisingly, the stock market took a hit after the CPI numbers, regained most of its losses and then resumed its slide on Friday with concerns about inflation supplemented by worries about a possible Iranian missile attack on Israel. Yields on Ten Year Treasuries spiked up before easing a bit on Friday, possibly benefitting a little from their perceived safe haven status. By the close on Friday, they stood at 4.52 percent. They had (briefly) fallen below 4 percent in February.
Writing for the Wall Street Journal, Nick Timiraos noted that this was the third straight month in which prices had risen by more than expected, and described the Fed as returning to an uneasy holding pattern, while waiting for better inflation data or clear signs of economic weakness. That better inflation data won’t (I suspect) be coming soon, at least on a sufficiently sustained basis to make the case for a rate cut. Perhaps reinforcing that point, the Producer Price Index (PPI) for March (released on Thursday) rose by less than expected (which helped bring some temporary relief to the stock market), but it still jumped from a year-on-year 1.6 percent in February to 2.1 percent in March.
Timiraos:
The latest [CPI] data raises two different possibilities. One is that the Fed’s expectation that inflation continues to move lower but in an uneven and “bumpy” fashion is still intact—but with bigger bumps. In such a scenario, a delayed and slower pace of rate cuts is still possible this year.
A second possibility is that inflation, rather than on a “bumpy” path to 2%, is getting stuck at a level closer to 3%. Without evidence that the economy is slowing more notably, that could scrap the case for cuts altogether.
Earlier this year, some on Wall Street had expected five or six rate cuts this year (Timiraos quotes a higher number still — six or seven) but those hopes have been dashed. Now expectations are one or two or three (no, this isn’t a precise science, in fact it’s not a science at all) weighted toward the latter part of the year.
One point worth reiterating is that interest rates are not particularly high when looking at historic levels. The problem is that they look positively Alpine compared with the levels they hit (and were) steered to in the 2010s, a period of cheap money extended by Covid-19. Adjusting to new, higher levels is proving tricky, and the worst is yet to come.
Once again, it’s time to quote some comments made a few years ago by Thomas Hoenig, a former president of the Kansas City Fed:
An entire economic system. Around a zero rate. Not only in the U.S. but globally. It’s massive. Now, think of the adjustment process to a new equilibrium at a higher rate. Do you think it’s costless? Do you think that no one will suffer? Do you think there won’t be winners and losers? No way. You have taken your economy and your economic system, and you’ve moved it to an artificially low zero rate. You’ve had people making investments on that basis, people not making investments on that basis, people speculating in new activities, people speculating on derivatives around that, and now you’re going to adjust it back? Well, good luck. It isn’t going to be costless.
As usual when I quote those words these days, my thoughts turn to the office property market, where the prospect of interest rates remaining at these levels is making a bad situation worse. Many office buildings were bought or built and financed on expectations and valuations distorted by cheap money. Now many of these buildings are up for refinancing as loans taken out at far lower rates fall due.
And prices have also been hit by the change to working patterns (many, many more people working from home for at least part of the week), a legacy of the Covid-19 lockdowns that has endured on a (to me) surprising scale. The situation is not helped by concerns about crime in some larger cities, as well as policy errors ranging from the rolling imposition in some cities of expensive climate-policy-related retrofitting on buildings to the upcoming introduction of New York City’s grotesque “congestion” charge. That anyone should think it sensible to discourage people from coming to a downtown which at the moment needs more traffic (in the broad sense of that word) is (or should be) remarkable.
State Assembly Democrats shot down a plan Tuesday that would’ve spared city workers, nurses and first responders from a hefty congestion toll to get to work in the Big Apple.
Doctors and patients seeking medical care in Manhattan would have also been exempted from the $15 toll under the plan — which was effectively killed by a move of the Committee on Corporations, Authorities and Commissions.
This does not seem like a formula for helping Manhattan emerge from its current woes.
There are plenty of horror stories in the office space to choose from (and they are not confined to the U.S.). The sale of the 44-story AT&T tower (909 Chestnut) in St. Louis, Mo., for a nominal $3.6 million (down from $205 million in 2006) has recently attracted a lot of attention. According to CoStar, that’s a price of $2.50 per square foot, down from $140 twenty years ago. Look a little closer and the picture becomes more complicated. Presumably assumption of debt and other accrued liabilities related to the building will mean the “real” price is somewhat higher, and the building won’t be cheap to fix up. Moreover, 909 Chestnut’s troubles predate the current mess. A report on its woes from 2012 includes this comment:
To make matters worse for nearby businesses [to the tower], many of the remaining employees telecommute from home rather than come into the office.
Another problem identified by Costar is “limited parking in downtown St. Louis,” another reminder — sorry New York — that some commuters like to drive, something also overlooked by the “urbanists” now busily engaged in a war against parking space, yet another front in the war against cars.
909 Chestnut last changed hands for a princely $4.5 million two years ago, and the property has been vacant since 2017, long before Covid-19. St. Louis itself has broader problems (and its office vacancy rate is 18.6 percent, higher than the national average in central business districts of 16 percent). Nevertheless, the lack of demand for the property is worth noting, as are some of the effects of the building’s emptiness. The block on which it stands was formally declared blighted by the city last year, a very specific case, perhaps, but still a warning of the wider urban damage that an empty or emptying building can cause. And then there’s the small matter of the hit to property tax revenues from plummeting building prices, the last thing that some embattled cities need.
And, looking at the CoStar report, there was also this: “The previous sale of 909 Chestnut… in 2022 resulted in a nearly $123 million loss to bondholders on the commercial mortgage-backed securities market.” As alluded to above, the problems in the office property sector is raising obvious questions about the health of the lenders exposed to it, a category that can include shadow banks (who lends to them?) and commercial real estate funds. The real estate company Newmark has estimated that $2 trillion of loans on commercial property will fall due between 2024 and 2026. With interest rates remaining “high,” the loans that replace them (if lenders can be found) will be significantly more expensive, hitting commercial property valuations still further. Refinancing worries will be with us for a while: According to Morgan Stanley, the peak refinancing year will be in 2027.
But maturity dates can be more flexible than it might first seem. In this sector, both lenders and borrowers see value in “extending and pretending” (basically modifying an existing loan) in tough times. This spares borrowers the pain of a full refinancing at rates which, according to Goldman Sachs, are the highest they have been for twenty years, and it spares lenders from foreclosing on properties at valuations that would mean that they have to take a nasty loss.
According to Goldman (this was back in March):
The average sales price for US offices has fallen by 33% since the 2019 peak on a per square foot basis, according to data collected from Real Capital Analytics (RCA). Central business districts of some cities like as Seattle, Los Angeles, and San Francisco, where distressed sales represent a large share of transaction volume, have seen average office sales prices fall by over 60% since the start of the pandemic…
Under the circumstances, it’s no surprise that some $270 billion of mortgage maturities were rolled over from 2023 to 2024. But this avoidance of reality cannot continue indefinitely, not least as the pricing at which deals are actually done (would-be bargain hunters seem to be emerging) increases the pressure on the extenders and pretenders to face the facts, something that they have, by definition, been unwilling to do. According to MSCI, commercial real estate transactions (a category that includes office buildings) were down 50 percent in 2023 in no small part because potential sellers were unwilling to take the loss that a price sufficiently low to attract buyers would entail.
One way or another, this may be changing. Foreclosures have increased dramatically this year, and, albeit very painfully, they can help establish a “real” price for office property, an essential precondition for the emergence of more buyers, and thus the beginnings (perhaps, in time) of a recovery.
Commenting on all this on March 20, the Financial Times’s Alexandra Scaggs noted that “sharply lower rates are what could possibly save US commercial property markets from a broader reckoning.” But, as discussed above, “sharply lower rates” are not on the cards any time soon.
One note of comfort comes from Goldman’s view that banks are far better poised to deal with this problem than they were prepared for the collapse in housing prices ahead of the financial crisis. That’s a low bar, and it may be too optimistic: A collapse in valuations in a sector this important will also certainly give rise to severe stress in some unexpected corner of the financial system with knock-on effects that can only be guessed at. In January, Barry Sternlicht, the billionaire CEO of Starwood Capital, estimated that the valuation of the office property sector had fallen from $3 trillion to around $1.8 trillion, meaning potential losses of $1.2 trillion, a number that may be hard to absorb. Somewhere the financial system is likely, so to speak, to spring a leak.
In his recently released CEO letter, JP Morgan Chase’s JP Dimon touched on this (my emphasis added):
When we purchased First Republic in May 2023 following the failure of two other regional banks, Silicon Valley Bank (SVB) and Signature Bank, we thought that the current banking crisis was over…However, we stipulated that the crisis was over provided that interest rates didn’t go up dramatically and we didn’t experience a serious recession. If long-end rates go up over 6% and this increase is accompanied by a recession, there will be plenty of stress — not just in the banking system but with leveraged companies and others. Remember, a simple 2 percentage point increase in rates essentially reduced the value of most financial assets by 20%, and certain real estate assets, specifically office real estate, may be worth even less due to the effects of recession and higher vacancies. Also remember that credit spreads tend to widen, sometimes dramatically, in a recession.
Also, channeling Thomas Koenig, Dimon added this:
We should also consider that rates have been extremely low for a long time — it’s hard to know how many investors and companies are truly prepared for a higher rate environment.
The Fed will be aware of this. It is set on getting inflation down, but how far will it push toward this objective if the troubles in the office market look like they are becoming unmanageable, creating a crisis that could have social and political consequences as well as economic?
And then there’s the ugly question of this country’s debt. In March last year, the Manhattan Institute’s Brian Riedl took a look at new CBO federal budget projections. It didn’t make for happy reading. Given the current discussion over interest rates, this passage is worth re-reading:
The cost of annual interest on this debt will leap from $350 billion two years ago, to $1.4 trillion a decade from now. At that point, 20 cents of every tax dollar will go toward paying interest on the debt — exceeding the cost of defense, Medicaid, and every program except for Social Security and Medicare. Even with the CBO assuming that the interest rate paid by Washington does not exceed 3.2 percent, interest costs will swell to a record 3.6 percent of GDP.
Every sentence in that passage is reason for gloom, above all, perhaps the one in which we read that the CBO assumes that the interest paid by Feds would not exceed 3.2 percent. That’s an assumption that currently looks more like a prayer. It suggests that, like so many others in our establishment, the team at the CBO had its expectations of the cost of money badly distorted by the ultra-low interest rate era. On some calculations those rates hit four-thousand-year (or more!) lows, but even those who might question that conclusion should have expected much more of a reversion to “normal” rates than they appear to have done.
Riedl has been worried about this for some time, and in 2021 wrote a paper in which he looked at the impact of higher interest rates on the nation’s finances (horrific, as we are already beginning to see) but that’s not a reason for the Fed to flinch before inflation is brought under control. After examining the history of interest rates since the 1950s, Riedl concluded that “low and stable interest rates require market confidence in low inflation rates.” And that confidence takes time to build. Moreover, some of the factors that (at least arguably) kept interest rates lower than they would otherwise have been in the last couple of decades (such as the savings “glut”) no longer weigh so heavily or may even have gone into reverse.
Additionally, new demands on capital are emerging that could by themselves push rates higher. Writing in 2021, Riedl noted that “even a gradual shift from fossil fuels to green technology will require significant new capital investments.” Since then, climate related spending has ballooned, and if governments on both sides of the Atlantic persist with their reckless and far from gradual “race” to net zero, the calls on capital (public and private) will be immense, running into the trillions. By early last year, economist Kenneth Rogoff was warning that “the massive costs of the green transition” would push up long-term interest rates as would “the coming increase in defense expenditure around the world.”
Prompted by Russia’s war on Ukraine, many NATO members have been increasing their defense spending towards or beyond the 2 percent of GDP target. But that target was first set in 2006, when relations with both Russia and China were relatively cordial. As recently reported in Bloomberg, “officials focused on security” believe that spending will have to reach 4 percent of GDP within a decade — roughly a return to Cold War levels — to be able to cope with the growing threat from Russia, China, and others. According to Bloomberg Economics, the cost for the U.S. and its largest G7 allies would be $10 trillion in additional commitments, more money which has to come from somewhere. The U.S. itself already spends 3.3 percent of GDP on defense, but getting to 4 percent by 2034 will add to a debt burden which is already likely to be in dangerous territory by then.
In the course of his 2021 paper, Riedl raised the awkward question of where the funding for America’s soaring debt would come from and had no comforting answers. While increasing international tensions increase the appeal of U.S. Treasuries and the dollar (as we saw in trading on Friday), that’s hardly a long-term solution, which may well — so long as the debt trajectory continues on its current course — involve higher interest rates if it is to attract buyers in sufficient numbers.
My guess (forecast is too strong a word) is that it will be a while before we see rate cuts, despite the office property sector woes. But if the Fed does start cutting, there is plenty to suggest that it will not be for long.
Capital Writing
As part of a project for Capital Matters, called Capital Writing, Dominic Pino will interview authors of economics books for the National Review Institute’s YouTube channel. This time, he talked with American Enterprise Institute’s Kevin Kosar, the editor of a new edition of Edward Banfield’s book Government Project. You can find an edited transcript of a few key parts of our conversation as well as the full video of the interview here.
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 National Review Institute 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 165th episode, David is joined by Larry Kudlow for the second episode in our Mentor Month series. Larry’s influence goes beyond the merits of supply-side economics. Whether it is sobriety or civility, temperament or loyalty, style or substance, David couldn’t do much better than striving to be like Larry Kudlow. No one could do much better than striving to be like Larry Kudlow.
The Capital Matters week that was . . .
Electric Vehicles
With new EVs accounting for well under 10 percent of new car purchases and significant improvements in charging infrastructure and range still years away, it seems likely that the EPA’s targets are optimistic — at least they would be if they weren’t the federal government and didn’t have the (in my view) unconstitutional ability to thump manufacturers who fail to meet arbitrary marks that have never seen a vote in Congress.
Just as hedging is taking place, so too is there a campaign of contempt aimed at legitimate concerns, as Pete Buttigieg exemplifies with McKinsey & Company flavor…
India
When Prime Minister Narendra Modi entered office in 2014, there were high hopes that the Indian leader would be a free-market reformer. “Government has no business to do business,” said Modi, responding to an accusation that his Bharatiya Janata Party (BJP) was turning into a socialist party. Yet, instead of free markets being at the forefront of the Indian economy, the state still plays a significant role in influencing economic relationships under Prime Minister Modi.
While India is the world’s fifth-largest economy and one of the fastest growing, it is categorized as “mostly unfree” by the Heritage Foundation’s latest Index of Economic Freedom…
Student Loans
One of the peculiar things about the White House’s announcement of more student-loan programs today is how it emphasizes that the “forgiveness” — which is really transferring the debt from borrowers to taxpayers — will in many cases come without any need for recipients to apply for it…
The Fed
In an era when regulators — for some reason, the EPA and the SEC come to mind — are extending their own jurisdiction, particularly where climate policy is involved, it’s good to read that the Fed has reportedly pushed back against an effort by European central bankers to require lenders to disclose “their strategies for meeting green commitments.” These rules would have been agreed to by the Basel Committee on Banking Supervision, the committee that sets international banking standards, albeit indirectly.
Office Property
The woes in the office-property market will not be confined to owners of buildings and those who have lent to them. The fall in buildings’ value will also have an impact on the cities that rely on commercial-property taxes for a significant portion of their revenue…
Germany
Economic troubles are coming to Germany, Europe’s largest economy, not as single spies but in battalions. They are also doing so at a time of domestic political weakness when the country lacks a coherent plan to restore its former economic strength. This does not bode well for Germany’s long-run economic prospects. It also will make it difficult for the euro zone’s economic periphery in general, and Italy and Spain in particular, to grow itself out from under its public-debt mountain…
Germany’s leading position in car manufacturing is the product of its long-honed expertise in this area. But the arrival of electric vehicles (EVs) means that many of the benefits of incumbency that Germany built up in the era of the internal combustion engine will be heavily diluted. That will be bad news for German automakers as Chinese EV-makers, well ahead in the rigged EV game, start taking market share. Making matters worse, China is not only a vital export market for German carmakers, but they also have a substantial presence there.
And if Germany’s automakers get into difficulty, political trouble won’t be far behind…
Inflation
I said it after last month’s inflation report, and I’ll say it again: We’re stuck…
More important now, I must warn again that the Fed alone won’t be able to cure our sustained inflation. Congress needs to fix the underlying fiscal problem. Not only is it not, the Biden administration also seems committed to its dual policies of pumping lots of money into the economy and constraining supply (think energy, trade, labor, investments, and more).
Add more than $1 trillion in interest payment this year, paid with more borrowing, and the many upcoming fiscal infliction points documented by our friends at EPIC, and you get a hint about why inflation is so hard to get rid of…
Kevin Hassett & Cale Clingenpeel:
In September 2022, we at Capital Matters advised readers that inflationary cycles had a predictable historical pattern. Today’s inflation data reveal that the regular historical pattern continues to be evident in the data. We are stuck at step eight of the ten steps of stagflation. Price inflation does not drop below wage inflation, so it stays high until the Fed really tightens…
Shareholder Rights
Last year, Ohio-based steel company Cleveland-Cliffs offered $35 per share in a half-stock, half-cash buyout to purchase U.S. Steel. Then, Japan-based Nippon Steel offered $55 per share, all-cash. U.S. Steel shareholders, naturally, prefer the much higher all-cash offer.
The senators who represent Ohio are mad about this, as is the United Steelworkers union.
Deindustrialization
ThyssenKrupp is a major German (yes, it includes that Krupp) engineering and steel company (its steel facility in Duisburg is Europe’s largest). Its steel business has struggled for a while and is now facing major production cutbacks…
Tariffs
Kayla is correct to note that a decline in overall public safety harms women more than men. She is also correct that a lot of “pink tax” talking points have more to do with consumer choices than with any kind of actual tax.
But there is one real pink tax the government levies: Tariffs on women’s clothes are, on average, higher than tariffs on men’s clothes.
The Workweek
For much of my adult life, economic policy in the United States followed a pattern: Democrats promised voters government largesse, and Republicans who objected were characterized as heartless bigots. Certainly, the promise of free money is attractive to voters, especially those in the bottom half of the income pyramid who don’t have to pay income taxes for the free stuff.
President Biden, perhaps driven by his unpopularity, has taken the free-money strategy to extremes, from the Inflation Reduction Act to student-debt forgiveness. This might carry Democrats through the next election, but the fact is that the president has spent so much that there isn’t enough money left to continue this strategy for much longer. Their new strategy is coming into view…
Education
Bloomberg has an article that reports on the findings from Georgetown University’s Center on Education and the Workforce about the return on investment for more than 1,500 four-year colleges in the U.S. It finds basically no correlation between the cost of tuition and the increase students’ expected earnings in the ten years after graduation.
It does find that Ivy League schools mostly provide graduates a very high return on investment compared with other schools. But non-Ivy elite colleges do not do very well, and in many cases they trail major public universities…
Industrial Policy
Free-market advocates will sometimes be mocked for comparing too many government programs to Solyndra. But can you blame us when, 13 years later, the federal government is giving more than ten times as much money to a company led by Solyndra’s former CEO?…
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