The big news today wasn't the Federal Reserve's decision to start gradually reducing its balance sheet in October.  Almost everyone expected that.  Instead, the big news was that twelve of the sixteen members of the Fed's interest-rate setting body – the Federal Open Market Committee – think the Fed will be raising interest rates by at least 25 basis points later this year.

As recently as two weeks ago, the futures market in federal funds was generating about a 20% chance of another rate hike this year.  Earlier today, before the Fed's statement, the odds were roughly 50%.  Now the odds are in the 60-65% range.  We think those odds are likely to rise even further in the months leading up to the December meeting.
 
In the meantime, the Fed will be reducing its balance sheet at a pace of up to $10 billion per month for the fourth quarter, increasing that to $20 billion monthly pace in the first quarter of 2018, $30 billion in Q2, $40 billion in Q3, and $50 billion in Q4.  After that, the Fed is projecting it would maintain that $50 billion monthly pace until it's satisfied with the size of the balance sheet.  This is no different than what the Fed said it would do three months ago at the meeting in June.  (For the foreseeable future, the balance sheet cuts would be 60% in Treasury securities and 40% in mortgage-related securities.) 

The Fed made some other changes to its "dot plot," but not in the near-term.  The dot plot still suggests three rate hikes in 2018.  However, back in June the median Fed path suggested three rate hikes in 2019, maybe four; now the Fed is torn between two or three rate hikes in 2019.  In addition, back in June the median Fed path suggested a long-term average funds rate of 3.00%; now it's 2.75%.

In terms of the Fed's economic outlook, there were barely any changes.  The Fed expects a little more real economic growth this year and a little less inflation, leaving nominal GDP growth (real GDP growth plus inflation) unchanged.  The Fed's statement was a little more bullish on business investment and made it clear it wasn't worried about the medium-term economic effects of Hurricanes Harvey and Irma. 

Notably, there were no dissents from today's statement, not even Minneapolis President Neel Kashkari, who made a dovish dissent two meetings ago back in June.

Although some may still fear the effects of the Fed renormalizing its balance sheet, we think the Fed should have started this process a long time ago and could even speed it up faster without hurting the economy.  Could long-term interest rates go up?  Sure they could!  But they should have been higher already given economic fundamentals.  While others fret about renormalization and rising rates damaging the economy or financial markets, investors should remain bullish.  Look for faster economic growth and a continuation of the bull market in equities in the years ahead. 

Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist

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Implications:  Existing home sales stumbled for a third consecutive month in August as a declining supply of homes continued to push up prices and frustrate potential buyers.  Sales of previously-owned homes fell 1.7% in August to a 5.35 million annual rate, and are now roughly flat from a year ago.  However, as a result of Hurricane Harvey, sales, which are counted at closing, were down 25% in the Houston area compared to a year ago.  According to the National Association of Realtors, which publishes the report, overall nationwide sales were unchanged outside of Houston.  Look for more downward pressure on sales for at least the next couple of months.  Some of the closings that should have happened in August may get shifted into September, but Harvey and Irma will both reduce the number of potential homeowners looking at and signing contracts on existing homes through September.  In turn, that means they will affect closings on existing homes through November, meaning we may not get a "clean" reading on sales until December.  However, when we get those clean reports we expect an upward trend in sales to re-emerge.  That said, the major headwind for sales has been the decline in inventories, which have now fallen on a year-over-year basis for 27 consecutive months and are down 6.5% from a year ago.  This has also affected the months' supply of existing homes – how long it would take to sell the current inventory at the most recent sales pace – which was 4.2 months in August, down from 4.5 months a year ago.  According to the NAR, anything less than 5.0 months is considered tight supply, a benchmark which hasn't been exceeded since November 2015.  Despite the lack of options, demand for existing homes has remained remarkably strong, with August marking the fifth straight month where a typical listing was sold in under 30 days.  Higher demand and a shift in the "mix" of homes sold toward more expensive properties has also driven up median prices, which have now risen for 66 consecutive months on a year-over-year basis.  The strongest growth in sales over the past year is heavily skewed towards the most expensive homes, signaling that supply constraints may be disproportionately hitting the lower end of the market.  Tough regulations on land use raise the fixed costs of housing, tilting development toward higher-end homes.  The NAR suggests that strong demand could also be pushing some properties into higher brackets as multiple offers boost final sales prices.  Although some analysts may be concerned about the impact of higher mortgage rates, it's important to recognize that rates are still low by historical standards, incomes are growing, and the appetite for homeownership is eventually going to move higher again.

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Implications:  Considering that Hurricane Harvey hit late in the month, the slight drop in housing starts in August is nothing to worry about.  Hurricane Irma may end up depressing home building in September as well, but storm-related rebuilding plus the solid fundamentals of the housing market should push starts to new recovery highs by early next year.  Note that all the drop in starts in August was due the extremely volatile multi-family sector (apartments, duplexes,...etc.), which fell 6.5% for the month and are down 24.7% from a year ago.  Meanwhile, single-family starts rose 1.6% in August and are up 17.1% from a year ago.  Surprisingly, permits for the volatile multi-family sector surged 19.6% in August and are now up 9.4% versus a year ago.   However, we don't think this signals a looming shift back toward multi-family starts on the horizon.  Multi-family led the way in the early stages of the housing recovery (2011-15).   By 2015, 35.7% of all starts were in the multi-family sector, the largest share since the mid-1980s, when the last wave of Baby Boomers was growing up and moving to cities.  Since then, the multi-family share of starts has been trending down, currently standing at 27.8%.  We expect that trend to continue.  The shift toward single-family is a positive sign for the economy because, on average, each single-family home contributes to GDP about twice the amount of a multi-family unit.  Based on population growth and "scrappage," housing starts should eventually rise to about 1.5 million units per year.  And the longer this process takes, the more room the housing market will have to eventually overshoot the 1.5 million mark.  In other recent housing news, the NAHB index, which measures sentiment among home builders fell to 64 in September from 67 in August.  That kind of dip is not unusual following a massive storm.  Expect further strength in the housing sector in the year ahead as more jobs, faster wage growth, and, for at least the time being, optimism about more market-friendly policies from the Trump Administration, continue to encourage both prospective home buyers and builders.  In inflation news, import prices rose 0.6% in August and are up 2.1% from a year ago.  Export prices increased 0.6% in August, and have increased 2.3% in the past year.  Both figures are a stark contrast to the negative direction of prices in the twelve months ending in August 2016.  With monetary policy loose, expect higher inflation readings in the year ahead.     

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Source: St. Louis Federal Reserve FRED Database

No one expects the Federal Reserve to raise rates at the meeting this week.  A rate change of any kind, either up or down, would be a complete stunner.  Instead, the big news on monetary policy this week is very likely to be the Federal Reserve announcing it will begin gradually trimming its balance sheet at the start of October.

The process of unwinding Quantitative Easing (QE) is going to take time, too much time in our opinion.  The Fed has said that whenever it starts, it's going to trim the balance sheet by $10 billion a month for the first three months, $20 billion per month for the next three, and on and on until it hits a pace of $50 billion per month.  So, if it starts cutting in October it would take until about 2021 for the balance sheet to reach what we believe is a normalized level.

We think the Fed could get away with being much more aggressive about reducing the balance sheet.  We don't think QE helped the economy in the first place; all it did was stuff the banking system full of excess reserves that the banks didn't lend.        

However, the Fed is cautious by nature; it hates getting blamed when anything goes wrong.  Think about it from their perspective:  Let's say they were more aggressive about trimming the balance sheet and suddenly the stock market had one of its inevitable corrections.  No matter the actual connection to the Fed's actions, many would blame the Fed.

Meanwhile, the Fed will also drop some hints about a potential rate hike at the end of the year.  Those hints could come from both the official statement following the meeting as well as Fed Chief Yellen's press conference afterward, but will certainly come from the "dot plot." 

Four times a year, every member of the Fed's Open Market Committee submits a forecast of where interest rates will be at the end of each of the next few years.  The Fed then publishes a chart showing these forecasts as anonymous "dots."  This dot plot is used by the market to assess the likelihood of interest rate changes.

Back in June, twelve of the sixteen dots showed at least one more rate hike by the end of 2017.  Now that a September rate hike isn't going to happen, and given the Fed's reluctance to move at meetings without a scheduled press conference (like on November 1), the number of Fed policymakers projecting at least one rate hike is very likely fewer than twelve.  But how many fewer?  We're guessing it'll show something like nine or ten (still a majority!) projecting a December rate hike.

If so, that would be a relatively hawkish sign considering the investor consensus embedded in the federal funds futures market at Friday's close showed a slightly less than 50% chance of another rate hike this year.  That's up from about a 20% chance a week and a half ago, but still below our view that a December rate hike has about 65% odds.
 
The Fed isn't the only central bank tilting toward a less loose monetary policy.  The Bank of England (BoE) and European Central Bank (ECB) also seem determined to start trimming back on some of the aggressive measures of the past decade.  The BoE looks like it will soon move rates up after having cut them to 0.25% in the aftermath of the Brexit vote last year.  Meanwhile, the ECB will start tapering its asset purchases.  We wish the ECB would also end its experiment with negative short-term rates, but that will likely take more time.

Regardless of what happens in the near future, central banks around the world remain extremely accommodative.  None of them are remotely close to running a "tight" monetary policy.  Yes, we've discussed the Fed here, but for investors, at this point it's best to ignore the noise.  Stocks are still cheap, the Fed is still loose, and the economy is still growing.  As long as there are "excess reserves" in the system, monetary policy will not threaten the recovery.  If it takes the Fed as long as we think to fully tighten, this recovery will end up being the longest ever.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist  

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Implications:  Following six straight monthly gains, industrial production in August declined the most for any month since 2009.  However, the overall 0.9% decline was mostly due to Hurricane Harvey, with the Federal Reserve saying the storm reduced both overall production and manufacturing in particular by roughly 0.75%.  The other big negative in today's report was for utilities, which fell 5.4%, primarily due to mild temperatures reducing demand for air-conditioning on the East Coast.  Excluding these effects – Harvey and mild temperatures in the East –industrial production would have been up close to 0.5% in August, which is consistent with the 1.6% gain in the past year.  Remarkably, auto production rose 2.2% in August.  Look for a bounce in overall production in the months ahead once the effects of Hurricane Irma also filter through the data and weather patterns return to normal.  In the meantime, it'll be a rocky ride.  Take mining, which fell 0.8% in August, held back by drilling and well service activity.  Harvey knocked oil and gas-well drilling down 4.7% in August, although it's still up a massive 86% from a year ago.  Look for a bounce back in drilling activity in the months ahead once the effects of the storms pass.  In other news this morning, the Empire State index, a measure of manufacturing sentiment in New York, fell to a still very high 24.4 in September from 25.2 in August, showing continued strength in the factory sector. 

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Implications: You can't forget about Hurricane Harvey when looking at the figures on retail sales in August.  Retail sales fell short of consensus expectations for August and were revised lower for June and July.  However, this doesn't mean consumers are throwing in the towel.  Retail sales are still up 3.2% from a year ago and "core" sales, which exclude volatile sectors, like autos, building materials, and gas, are up 2.8%.  Hurricane Harvey, which smashed Houston and surrounding areas late in the month, likely turned what would have been a gain in sales in August into a decline.  Now, with Hurricane Irma striking Florida this month, we're at least a couple of months away from being able to see sales data that reflect the underlying trend. These hurricanes hurt sales in the very short run – who is going to buy a car or furniture right before a major storm? – but then sales can bounce in the months that follow, both due to temporary pent-up demand plus the purchase of replacements for what was destroyed.  For example, carmakers reported sales at a 16.1 million annual rate in August, the slowest pace for any month since 2014.  But sales should surge back to at least a 17 million annualized pace in the fourth quarter as vehicles totaled in the storm get replaced.  The decline in sales in August itself was led by autos.  In addition, non-store retailers, which includes mail-order and internet sales, fell 1.1%, the largest monthly drop in three years.  These figures are volatile from month to month, so it could be statistical noise.  Then again, it could also be consumers fixated on weather-related news, as well as making preparations, crowding-out time otherwise used to shop online.  The largest gain in sales in August was for gas stations as gas prices rose due to Harvey.  We'll likely see more growth in gas station sales in September due to Irma, before they drop later in the year as refineries get back to full speed and pump prices decline.  When all is said and done and the effects of the hurricanes are fully behind us, we expect the data to show continued Plow Horse growth in consumer spending.  Jobs and wages are still moving up, consumers' financial obligations are an unusually small part of their incomes, and serious debt delinquencies are down substantially from seven years ago.

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Implications:  Consumer price inflation in August was the hottest for any month since January, with prices rising 0.4%.  But, between Hurricanes Harvey and Irma, we're going to have to wait a couple of months to figure out whether there has been a shift in the underlying trend.  The increase in prices in August was led by gasoline and housing costs.  We're certain to see more upward pressure from gas prices in September as Harvey hit late in August, and so only affected prices for a small part of the month.  In the past year, consumer prices are up 1.9%.  This is below the Federal Reserve's 2% target, and so some are saying the Fed should hold off on raising rates in December.  But consumer prices were up only 0.2% in the year ending in August 2015 and up 1.1% in the year ending August 2016, so seeing through temporary fluctuations, we think inflation has remained in a rising trend.  "Core" consumer prices, which exclude food and energy, rose 0.2% in August and are up 1.7% from a year ago.  A closer look at core prices shows a handful of goods that are keeping that measure below the 2% inflation target. Cellphone service prices have declined an unusually large 13.2% in the past year, while major household appliances are down 3.9% and vehicle costs are falling.  For the consumer, these falling prices - which are the result of technological improvements and competition – plus rising wages mean increased spending power on all other goods.  We still expect inflation to trend towards 2%+ in the medium term, and don't think the gains to consumers from falling prices in select areas are reason for concern or a justification for the Fed to hold off on a steady path of rising rates.  A week ago, the futures market put the odds of a December rate hike at only 22%; now those odds are up to 47%.  We think they should be more like 65%.  The most disappointing news in today's report is that real average hourly earnings declined 0.3% in August.  However, these earnings are up 0.6% over the past year.  On the jobs front, initial claims for unemployment benefits declined 14,000 last week to 284,000.  The recovery from Harvey should keep exerting downward pressure on claims over the next couple of weeks.  Unfortunately, Irma will likely exert even more powerful upward pressure in the near term, so next week's report in claims should rise to about 300,000.  After that, claims should drop over the following few weeks back to about 240,000, where it was before the hurricanes.  In the meantime, continuing claims for unemployment benefits fell 7,000 to 1.94 million.  Plugging all this data into our models suggests payroll gains will be muted for September, but then bounce back in the fourth quarter of the year.

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Implications:  Producer prices rose 0.2% in August, led by a 9.5% jump in gasoline prices.  While initial glances may wave this off as an effect of Hurricane Harvey, the PPI survey takes place in the middle of the month, so the hurricane-related rise in gasoline costs that started in late August, and will now carry through to September, were not reflected in this report.  Looking beyond energy, rising costs for chemicals, light trucks, and potatoes helped to push goods price up 0.5% in August.  Service sector prices rose in August as well, with margins for retailers and wholesalers pushing service prices up 0.1%.  The numbers arguably most important in today's report – which comes less than a week before the Fed begins their two-day meetings next Tuesday – are the twelve-month price changes.  In the past year, producer prices have increased 2.4%, while prices excluding food and energy have increased 2%.  And even if prices are unchanged in September - very unlikely due to the hurricanes - both of these numbers will remain at or above the Fed's 2% inflation target.  A look further down the pipeline shows price increases for intermediate goods well above 2% in the past year.  Intermediate processed goods rose 0.4% in August and are up 4.1% from a year ago, while unprocessed goods declined 0.7% in August but remain up 6.8% in the past year.  As a result, today's data should bolster the Fed's view to announce the start of balance sheet normalization at this month's meeting and signal plans for one more rate hike in December. 

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The Panic of 2008 was damaging in more ways than people think.  Yes, there were dramatic losses for investors and homeowners, but these markets have recovered.  What hasn't gone back to normal is the size and scope of Washington DC, especially the Federal Reserve.  It's time for that to change.

D.C. institutions got away with blaming the crisis on the private sector, and used this narrative to grow their influence, budgets, and size.  They also created the narrative that government saved the US economy, but that is highly questionable.

Without going too much in depth, one thing no one talks about is that Fannie Mae and Freddie Mac, at the direction of HUD, were forced to buy subprime loans in order to meet politically-driven, social policy objectives.  In 2007, they owned 76% of all subprime paper (See Peter Wallison: Hidden in Plain Sight).

At the same time, the real reason the crisis spread so rapidly and expanded so greatly was not derivatives, but mark-to-market accounting.

It wasn't government that saved the economy.  Quantitative Easing was started in September 2008.  TARP was passed on October 3, 2008.  Yet, for the next five months markets continued to implode, the economy plummeted and private money did not flow to private banks.

On March 9, 2009, with the announcement that insanely rigid mark-to-market accounting rules would be changed, the markets stopped falling, the economy turned toward growth and private investors started investing in banks.  All this happened immediately when the accounting rule was changed.  No longer could these crazy rules wipe out bank capital by marking down asset values despite little to no change in cash flows.  Changing this rule was the key to recovery, not QE, TARP or "stress tests."
 
The Fed, and supporters of government intervention, ignore all these facts.  They never address them.  Why?  First, institutions protect themselves even if it's at the expense of the truth.  Second, human nature doesn't like to admit mistakes.  Third, Washington DC always uses crises to grow.  Admitting that their policies haven't worked would lead to a smaller government with less power.

The Fed has become massive.  Its balance sheet is nearly 25% of GDP.  Never before has it been this large.  And yet, the economy has grown relatively slowly.  Back in the 1980s and 1990s, with a much smaller Fed balance sheet, the economy grew far more rapidly.

So how do you drain the Fed?  By not appointing anyone that is already waiting in D.C.'s revolving door of career elites.  We need someone willing to challenge Fed and D.C. orthodoxy.  If we had our pick to fill the chair and vice chair positions (with Stanley Fischer announcing his departure) we would be focused on the likes of John Taylor, Peter Wallison, or Bill Isaac.

They would bring new blood to the Fed and hold it to account for its mistakes. It's time for the Fed to own up and stop defending the nonsensical story that government, and not entrepreneurs, saved the US economy.  Ben Bernanke and Janet Yellen have never fracked a well or written an App.  We need a government that is willing to support the private sector and stop acting as if the "swamp" itself creates wealth.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist  

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