At the beginning of the year, many economists and Federal Reserve officials were gloating over falling US inflation. ‘Team transitory’ had been vindicated and, even more important, the economy was experiencing ‘immaculate disinflation’, which would allow the Fed to cut interest rates even while jobs remained plentiful. Stock and bond markets were euphoric, with falling yields and rosy profit expectations pushing major US stock indices to all-time highs during the first quarter of 2024.
In recent weeks, however, markets have stumbled. Bond yields have jumped to their highest levels in six months and global equity markets have dipped. Talk of an equity market ‘correction’, implying a decline of more than 10% from peak levels, is growing louder.
To be sure, this might simply be ‘noise’. Markets are prone to excesses, and after surging from October 2023 until March 2024, global equity markets were probably overdue for a consolidation.
But maybe something else is at work—something more nefarious. Perhaps, contrary to the exuberance of early 2024, US inflation will not be so easily vanquished.
That’s worth pondering, not just because of what it may mean for investor portfolios, but because it could prove crucial to the outcome of the November US elections.
Sticky Inflation
In short, it’s all about sticky inflation, which stopped falling a couple of months ago across an array of measures.
That requires some explanation. But rather than go through the arcane micro-details of US inflation indices, it may be easier (at least I hope) to think about this through a model frequently employed in introductory macroeconomics, one that links the economy’s productive potential (aggregate supply) to its total spending (aggregate demand).
Specifically, most of the past 12 months has produced a wonderfully soothing story about expanding supply-side potential in the economy, as pandemic-related bottlenecks were alleviated and immigrants surged into the labor force, allowing the economy to grow while price pressures dissipated.
But while that story was accurate for swathes of the economy, one sector didn’t participate: US housing. Instead, the US housing market has become increasingly gummed up, reflecting excess demand and insufficient supply on a scale not seen elsewhere in the economy.
On the demand side, strong jobs growth, immigration, and an increasing number of households as a percentage of the population (i.e., fraction of the population needing a roof over its head) has produced lots of folks looking to rent or purchase a home. Indeed, the number of dwelling seekers is particularly high compared to past Fed-tightening episodes, when rising unemployment typically depressed housing demand.
But it is on the supply side that things are genuinely out of kilter. Many existing homeowners, who for personal or occupational reasons might be ready to sell, are unwilling to do so today. That’s because they enjoy low, fixed-rate mortgages taken out during the Fed’s zero-interest rate era. Understandably, they are unwilling to sell and re-purchase at prevailing punishing mortgage rates.
To wit, today there are only half as many existing homes listed for sale in the US as there were eight years ago, despite more prospective home buyers. Simply put, existing home inventory is exceedingly tight.
Meanwhile, homebuilders are unwilling to borrow at soaring interest rates. Hence, the customary beehive of US subdivision building is eerily absent. Indeed, compared to their post-pandemic peak in April 2022, US housing starts have plunged by a half million units by March 2024.
The net effect is a significant imbalance between demand and supply in the US housing market. Unsurprisingly, housing price and rental inflation measures are running at rates not normally seen two-years into a Fed tightening campaign. For example, the widely followed Case-Shiller Home Price Index has surged nearly 6% over the past 12 months. US annual rent inflation is running at 5.7%, slower than a year ago but nevertheless well above its 3.3% average annual rate since 1990.
Why This Matters
But wait, isn’t inflation about more than just housing? Well, these days, not really. After all, for the widely followed core consumer price index (CPI) measure of inflation, housing (shelter) carries a hefty 45% weight. It is a smaller, but still chunky 18% of the Fed’s preferred core personal consumption expenditures index.
To see how today’s housing inflation matters, if we strip out shelter inflation from core personal consumption expenditures inflation, the six-month annualized rate of inflation drops to the Fed’s 2% inflation objective.
But, in the end, the story is about much more than housing. To see why, we must return to the stock market.
If elevated house price inflation means that overall inflation remains stuck above the Fed’s 2.0% target, then the benign story of positive shifts in aggregate supply allowing both falling inflation and rising output is over.
In its place, comes the specter of the Federal Reserve needing to curb aggregate demand (total spending) to wring the vestiges of excess inflation out of the system.
If that second scenario is becoming more likely, it implies that either monetary or financial conditions must tighten to slow spending. If so, then as Larry Summers recently mused, the next Fed move may be a hike, not a cut. That would be most unpleasant for the stock market.
Alternatively, the Fed’s aims could be accomplished if financial conditions exert restraint. That could be accomplished by a falling stock market (and a widening of credit spreads), which would curb total spending in the economy via negative wealth effects and a rise in the cost of capital.
But under either scenario, investors may have to gird for a deeper equity market correction.
And, lastly, it is not just investors who might take note. President Biden has cut into President Trump’s lead in opinion polls, and a strong economy is surely to Biden’s benefit. But if the stock market crashes at some point in the next six months, one of Biden’s trump cards (apologies), namely a strong economy, will vanish.
So, a lot is at stake.
Plenty of Americans want to get on the housing ladder. Others want to move up the same ladder. Everyone wants plentiful jobs. The Fed also wants low inflation. And investors want strong markets.
President Biden wants it all, too. But can the good times continue? Let’s see.