This week traditionally marks the end of the “Silly Season,” as the media regards August because the shortage of news during vacation season promotes to page one headlines like MAN BITES DOG.
The US financial world this August including the Fed has been quiet and happy. Inflation has reached the Fed’s 2% target, the economy is both good and sound, and the Fed contemplates a pause in its rate hikes. What could go wrong?
The primary risks lie overseas, the hazards hard to estimate. Markets did not care for Mr. Trump’s confirmation of intent next week to slap tariffs on $200 billion of China’s goods, and to pull out of the World Trade Organization unless it does what he says. On the other hand, most of our trade offensive is noise, “deals” far from ratified by Congress and anyway of little economic import except to annoy everyone else.
The new, the go-it-alone US is creating some strange happenings. Turkey as a society is reverting from the great modernizations of Kemal Ataturk after WW I, back to the preceding Ottoman Empire, “the sick man of Europe.” The US has imposed sanctions on Turkey, our NATO ally because it will not release pastor Andrew Brunson, accused as an agitator. The sanctions are pushing mismanaged and rickety Turkey into a financial heap requiring an IMF bailout which the US would veto. Germany proposes a European bailout of Turkey, fearing it as the control valve for a new flood of refugees, and Spanish and French banks packed with Turkish wallpaper. Imagine Europe, which has yet to bail out itself trying to bail out Turkey. All-in… silly but dangerous.
The US for 120 years was the key to global stability. Was. Trump may ultimately provide an unintended but useful lesson both at home and abroad: If we wish to have a civilization we must cooperate with each other, including people and nations whom we do not like.
Back to the fun stuff. The world has no early warning system for the US as destabilizer, but early warnings are hard to find for most future events. The Fed doesn’t have a good one, either. Chair Powell last week ridiculed the utility of the Fed’s cherished technical benchmarks and emphasized the exercise of judgment. The seat of the pants is in the chair.
Warning systems are tricky things. On Tuesday California barely felt a 4.4 magnitude earthquake, but designers of its new, $22 million early warning system were pleased. The L.A. Times: “The system sent out a warning three seconds before the shaking began.”
Three seconds. The system does not predict earthquakes. It just relies on quake shock moving slowly, at sound-speed and an electronic warning moving at light speed — the same as the delay from lightning flash to the sound of thunder.
The Times said a few seconds is enough “to drop, cover and hold on before shaking,” or to auto-stop elevators, or (ouch) for “surgeons engaged in operations to put down scalpels.” For me… just enough time to drain my drink.
The Fed’s most reliable warning of economic trouble has been housing. In prior cycles we have been able to see overheating or collapse many months, even years ahead. Sometimes we have acted on the warning, sometimes not. Right now the financial press is pleased to announce that housing is slowing. By micrometers. These gleefully gloomy reports have more to do with competitive envy than economic forecast.
A group of professional friends met here this week to ponder local statistics which we have never seen before. Louisville CO is a sweet suburban town, population 18,376 last year, often ranking high among best places to live, but all of its developable land exhausted. As of last week Louisville had nine homes for sale not under contract. NINE. Prices are rising about 10% annually for the sixth-straight year. Is that condition a “slowdown?” It’s just like most attractive communities in the US — sales are slow because nothing to sell.
Wannabe analysts of housing also like to write about “affordability,” and especially declining affordability. Sure, interest rates have nudged up from the mother of all-time lows, and urban home prices nationwide have been rising on a 6% slope since roughly 2013 and foreclosure abatement. Every time you see one of these affordability stories, ask yourself: “If these things are not affordable, why do they sell as soon as they’re listed?”
The Fed’s early-warning problem is similar to all of the above. Crucial to the Fed’s forecasting of inflation is the concept of “inflation expectations.” Not the Fed’s expectations, but ours. Way back in the terrible inflation of the 1970s which crested at 18% annualized, we civilians were a leading cause of increasing inflation. We demanded raises bigger than inflation, we wanted and got “cost of living” increases in fixed incomes, we scrambled to buy things today — borrowing if necessary — before prices went up tomorrow, thereby guaranteeing that prices would ramp up.
Our expectations broke in the 1980s. But the Fed continued to infer expectations by measuring long-term rates versus short ones, and inflation-protected rates versus fixed ones, and in the last fifteen years have announced the obvious: “Inflation expectations are well-anchored.” Duh. Deflation has been the problem. How will we know when inflation becomes un-anchored?
I am unhappy with the Fed’s expectation analysis, all circular, markets watching the Fed, the Fed watching markets. Here is a real-world thought experiment. Today we constantly hear legitimate reports of labor shortages, usually at low-end jobs. Why not offer to pay more? Because then the employer’s prices would be forced up to non-competitive. After a long period of wage stability, and during a time of intense global competition it is hard to get wages moving upward. In today’s conditions it would require an entire market to begin to raise wages in concert, so as not to lose competitive advantage.
Query: Would it be an anti-trust violation if all construction employers conspired to raise wages? Only if they also raised prices.
Let’s suppose inflation rises from 2% to some monthly readings at 3%, wages spiraling above inflation in spots. The Fed would then hike rates until the economy slowed, maybe a dish-shaped recession. Not bad, if that’s all the medicine involved. However, having lived and worked through the 1960s-1970s wage-price spiral, once they get going these spirals are hell to stop.
Mercifully, they are also hard to get going. We’ll see one coming in plenty of time, so long as no one stays the Fed’s hand.
The 10-year US T-note shows no sign of moving up after the Fed last week confirmed two or three more .25% hikes in the cost of money soon ahead, nor any fear of future inflation:
The 2-year T-note is the Fed signal. The Fed is presently at 2.00%, headed for 2.50%-2.75%. In all cycles the 2-year rises above the Fed until it feels a Fed stop ahead. Just as 2s front-run the hikes, they front-run the stop — as they have now: