In this week’s “Three on Thursday,” we explore the Personal Consumption Expenditures (PCE) Price Index, which became the Federal Reserve’s preferred inflation gauge starting in 2000. This shift occurred after Federal Reserve Chairman Alan Greenspan highlighted its advantages in The Monetary Policy Report to Congress. The Fed favors the PCE Price Index over the Consumer Price Index (CPI) for several reasons.

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Implications:  Existing home sales took a widely expected breather in March following the largest monthly gain in a year in February. While sales activity has finally bottomed it looks like any significant recovery is still facing headwinds from mortgage rates that remain above 7%. Mortgage rates had been dropping in early 2024, but that trend has recently reversed. The culprit is a recent string of bad inflation reports that have cast doubts on the Federal Reserve following through with rate cuts this year. Meanwhile, home prices appear to be rising again, although modestly, with the median price of an existing home up 4.8% from a year ago.  The result is that affordability is still a big concern for buyers.  Assuming a 20% down payment, the rise in mortgage rates since the Federal Reserve began its current tightening cycle in March 2022 amounts to a 34% increase in monthly payments on a new 30-year mortgage for the median existing home.  Eventually, the housing market can adapt to these increases but continued volatility in financing costs will cause some indigestion.  The other major headwind for sales has been that many existing homeowners are reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  This continues to limit future existing sales (and inventories).  However, there are signs of progress with inventories rising 14.4% in the past year.  That said, the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) was 3.2 in March, well below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.  A tight inventory of existing homes means that while the pace of sales looks like 2008, we aren’t seeing that translate to a big decline in prices.  Putting this together, we expect a modest recovery in sales in 2024.  In other news this morning, initial claims for jobless benefits remained unchanged last week at 212,000, while continuing claims rose by 2,000 to 1.812 million.  The figures are consistent with continued job gains in April. Finally, on the manufacturing front, the Philadelphia Fed Index, a measure of factory sentiment in that region, jumped to +15.5 in April from +3.2 in March.

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Implications:  Industrial production continued to rebound in March, rising for a second month due to broad-based gains. The manufacturing sector was the main source of strength in today’s report, with activity rising 0.5%.  Auto production jumped 3.1% in March and has been a big driver of activity so far in 2024. This measure is up at a 10.1% annualized rate in the past three months, likely the result of production still getting back on track following large scale strikes late last year. Meanwhile, non-auto manufacturing (which we think of as a “core” version of industrial production) posted a moderate gain of 0.3% in March. The production of high-tech equipment also rose in March and is up 14.1% in the past year, the strongest growth of any major category.  This likely reflects investment in AI as well as the reshoring of semiconductor production. Notably, activity here has begun to slow recently signaling that the initial burst due to the CHIPS Act may finally be wearing off.  The utilities sector (which is volatile and largely dependent on weather) was also a tailwind in today’s report, rising 2.1% in March.  Finally, the one source of weakness in March came from the mining sector, with activity falling 1.4%.  Broad-based declines in oil and other mineral extraction more than offset a small increase in natural gas production.  However, given the recent jump in energy prices, we expect a rebound in mining in the next couple of months.   

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Implications:  Housing starts posted the largest monthly decline in March since the worst of the COVID pandemic, coming in well short of consensus expectations.  However, this follows a surge in starts in February and we do not see March as a sign of persistent weakness ahead in home building.  While the data have been very choppy since the Federal Reserve began the current tightening cycle two years ago, it looks like construction activity has bottomed; even with the large drop in March, starts are still above the level from last August.  Keep in mind that many owners of existing homes are hesitant to list their homes and give up fixed sub-3% mortgage rates, so many prospective buyers have turned to new builds as their best option. This has boosted demand for developers and should help construction activity going forward.  The problem is that with recent inflation reports having come in hotter than expected, the markets – and the Fed itself – seem increasingly doubtful about near-term rate cuts.  As a result, long-term interest rates have gone up including mortgage rates.  In turn, this could generate a temporary headwind for home sales and housing starts in April.  Looking at the details of the report, the slowdown in construction in March was broad-based with three out of four major regions and both single-family and multi-unit starts contributing.  Housing permits and completions also took a breather in March, dropping 4.3% and 13.5%, respectively.  Another recent theme is the split between single-family and multi-family development.  Over the past year, the number of single-family starts is up 21.2% while multi-unit starts are down 44.3%.  Permits for single-family homes are up 17.4% while multi-unit home permits are down 20.2%.  This huge gap in the data is due to the unprecedented nature of the last four years since COVID began.  While we don’t see housing as a major driver of economic growth in the near term, we don’t expect a housing bust like the 2000s on the way, either.  Builders built too few homes in the decade before COVID and that shortage should support home prices in the years ahead.  In other housing news, the NAHB Housing Index, a measure of homebuilder sentiment, remained at 51 in April.  This marks the second month in a row that the index is above 50 since last Summer, signaling that a greater number of builders view conditions as good versus poor.

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Implications:  Retail sales beat expectations in March, rising 0.7% for the month versus a consensus expected gain of 0.4%, while previous months were revised higher.  Factoring these in, retail sales grew an even faster 1.3%.  These figures add to a trove of recent reports pulling the Federal Reserve away from rate cuts starting in June.  Sales rose in eight of thirteen major categories for the month, led by a robust 2.7% gain in nonstore retailers (think internet and mail-order), followed by a 2.1% increase at gas stations, which rose largely due to higher gas prices in March.  The largest decline in March was a 0.7% drop for autos.  “Core” sales, which exclude volatile categories such as autos, building materials, and gas stations — and is a crucial measure for estimating GDP — surged 1.0% in March (+1.4% including revisions to prior months).  After looking weak in the first two months of 2024, these sales ended up increasing at a 2.2% annual rate in Q1 versus the Q4 average.  It’s important to remember that a key driver of overall spending is inflation.  While overall retail sales are up 4.0% in the last year and sit at a record high unadjusted for inflation, “real” (inflation-adjusted) retail sales are up just 0.5% in the last year, and have remained stagnant for nearly two years after peaking in April 2022.  It has been 40 years since the US had an inflation problem, so investors should be aware that it can distort data.  Our view remains that the tightening in monetary policy since 2022 will eventually deliver a recession.  In other news this morning, the Empire State Index, a measure of New York factory sentiment, rose to -14.3 in April from -20.9 in March.

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Many, us included, see parallels between today’s big issues and those of the 1960s and 1970s.  Mistakes in both geopolitical and fiscal policies compound overtime, often leading to more mistakes. After Vietnam ended badly, US weakness likely encouraged terrorism.  The 1972 Munich Massacre of Israel Olympic Athletes, Entebbe in 1976, and finally US hostages held in Iran from 1979 to 1981.

At the same time both fiscal and monetary policy became unhinged.  The result was stagflation, with inflation hitting and unemployment approaching double digits.  We don’t have room for a complete historical explanation, but Presidents Johnson, Nixon, Ford, and Carter each made mistakes in either foreign or fiscal policy that led to these problems.

Then, Ronald Reagan was elected, and while his opponents claimed he would cause nuclear war, the exact opposite happened.  Stagflation was ended, the Berlin wall fell, and the world entered a mostly peaceful era.  Elections matter.

With Iran attacking Israel over the weekend, and unsustainable budget deficits eroding the US fiscal situation, we are reminded of the 1970s.  In fact, there were two decisions made under President Carter almost fifty years ago that have helped create both of these issues.

We focus on policy, not personality.  We are not attacking President Carter himself.  He appears to be a very good and decent man.  His great charitable work after leaving the presidency speaks for itself and sets a great standard for other former officeholders.  In addition, President Carter bucked his party and deregulated both the trucking and airline industries.

However, Carter also made some serious blunders.  On the geopolitical front, it was Carter who decided (1) not to back the Shah of Iran in 1978 and after that (2) not to pursue regime change in Iran after the seizure of American hostages and a coup d’état against the duly-elected Iranian President Banisadr (who had to flee for his life back to France).

Now the Islamic Republic of Iran effectively controls Syria, much of Iraq, Lebanon, Gaza, some of Yemen, and in the meantime is aligning with rivals of the US, such as China and Russia. With every passing decade it has become more difficult to dislodge the regime in Iran and now, in the absence of a change in the near future, it may only be a matter of time before Iran is able to acquire a nuclear weapon.

On the fiscal side, President Carter also championed an arcane but incredibly important change to Social Security enacted in 1977.  This change virtually guaranteed the long-term insolvency of the old-age pension portion of the Social Security system unless future policymakers agree to some combination of tax hikes or benefit cuts.

Before these changes were made, Social Security payments were adjusted by inflation, what we call the cost-of-living adjustment (COLA).  Until the mid-1970s, Congress had to vote to make this adjustment and politicians took credit every time they did.  But, as inflation became more of a problem, the annual COLA was tied directly to the Consumer Price Index.

The COLA adjustment automatically increased both current and future benefits.  But Carter added a wrinkle.  Current recipients would receive the COLA adjustment, but future benefits would rise by both the COLA plus an estimate of real wage gains.  At first this made little difference, but through the magic of compounding, this adjustment for real wages adds up and the current trajectory of payments is unsustainable.

Carter and other policymakers were warned about this problem at the time, but didn’t pay it heed.  No wonder people see similarities between today and the 1970s.  Current policies and past policies are colliding to create the very same problems.  As November approaches, voters would do well to remember this history.  Their decisions are not just about the next few years, but will resonate for decades to come.  Solid US leadership can change the entire world.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:   Do you hear that sound?  It’s the door creaking closed on the chances for a June rate cut. While the producer price index rose a modest 0.2% in March, that comes on the back of above-trend increases the prior two months.  Through the first three months of 2024, producer prices rose at a 4.4% annualized pace, while year-ago comparisons are on the rise and now back above 2.0% for the first time since April of last year.  Paired with consumer price data out yesterday showing inflation re-accelerating, the Fed is unlikely to feel the confidence that the inflation fight is won.  Looking at March itself, lower energy costs helped keep producer prices contained, down 1.6% on the back of falling gasoline prices, while food prices – the other typically volatile category – rose 0.8% on a jump in costs for processed poultry.  Stripping out these two components shows “core” prices rose 0.2% in March, following an outsized 0.5% increase in January and a 0.3% rise in February.  While the Fed can take some solace in noting the twelve-month rise in core prices has eased since peaking at 9.7% back in March of 2022, they remain up 2.4% in the last twelve months and accelerated to a 4.2% annualized rate over the first three months of 2024.   The 0.2% rise in core inflation in March was led by services, up 0.3%, while goods prices outside of food and energy rose 0.1%.  The largest price increases came from securities brokerage, commercial equipment wholesaling, and airline passenger services, which were partially offset by lower costs for traveler accommodations and auto retailing.  Further back in the pipeline, processed goods prices fell 0.5% in March and are down 1.7% in the past year, while unprocessed goods prices declined 1.9% in March and are down 7.1% in the past year.  Further easing in inflation will come should the Fed have the patience to let a tighter monetary policy do its work.  But inflation risks rearing its ugly head once again should the Fed falter and cut rates too quickly.  The markets – and the Fed itself – seem increasingly doubtful that rate cuts are near. And for good reason. In other news this morning, initial claims for jobless benefits fell 11,000 last week to 211,000, while continuing claims rose by 28,000 to 1.817 million.  The figures are consistent with continued job gains in April.

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In this week’s edition of “Three on Thursday,” we look at the Federal Reserve’s financials through year-end 2023. Back in 2008, the Federal Reserve (the “Fed”) embarked on a novel experiment in monetary policy by transitioning from a “scarce reserve” system to one characterized by “abundant reserves.” In addition to inflation, this experiment has resulted in some other developments that are worrisome.

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Implications:   Where is the evidence that monetary policy is tight?  Consumer prices rose 0.4% in March, pushing the twelve-month comparison up to 3.5%.   At this point it looks clear that the progress against inflation made from mid-2022 to mid-2023 has stalled.  Consumer prices were up 9.1% in the year ending in June 2022.  While many thought the drop back to 3.0% in the year ending in June 2023 was all due to the Fed, it was likely influenced greatly by supply chain disruption and recovery.  With CPI inflation back up to 3.5% from a year ago, it is clear that the problem has not gone away.  Looking at the details, March inflation was boosted by energy prices, which rose 1.1% on the back of higher prices for gasoline.  However, it’s important to point out that energy has not been the culprit for the stubbornly high inflation readings over the last year; energy prices are up 2.1% in the same timeframe versus 3.5% for overall prices.  Stripping out energy and its often-volatile counterpart (food) to get “core” prices does not make the inflation picture look any better.  That measure rose 0.4% in March for the third consecutive month, while the twelve-month comparison remained at 3.8%, proving that underlying pricing pressures remain stubbornly high.  Rental inflation – both for actual tenants and the imputed rental value of owner-occupied homes – continue to defy predictions of imminent reversal, rising 0.4% for the month and running at or above a 5% annualized rate over three-, six-, and twelve-month timeframes.  Housing rents have been a key driver of inflation over the last year, and we expect it to continue to do so, as it makes up a third of the weighting in the overall index and still hasn’t caught up with the rise in home prices in the past four years.  But the most troublesome piece of today’s report for the Federal Reserve came from movement in a subset category of prices that the Fed itself has told investors to watch closely – known as the “Supercore” – which excludes food, energy, other goods, and housing rents, and is a useful gauge of inflation in the services sector.  After large monthly increases in January and February, that measure jumped another 0.6% in March, driven by higher prices for motor vehicle insurance (+2.6%) and medical care services (+0.6%).  In the last twelve months, this measure is up 4.8% and has been accelerating as of late; up at 8.2% and 6.1% annualized rates in the last three and six months, respectively.  And while inflation remains stubbornly high, workers are no longer being compensated for it.  Case in point, real average hourly earnings were unchanged in March.  These earnings are up only 0.6% in the last year, a headwind for future growth in consumer spending.  Putting this all together, the Fed has little reason at this point to start cutting rates.  How they respond to the incoming economic data in the months ahead could determine whether we repeat the inflationary 1970s.

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In the waning seconds of one of the most watched women’s college basketball games ever, a foul was called.  The University of Connecticut was playing the University of Iowa in the semi-finals of the women’s NCAA championship tournament.  Officials called a UConn player for an “illegal screen” on an Iowa defender, which helped Iowa win the game.  This happened Friday night, and on X (formerly Twitter) the debate about this call still rages.

In spite of the debate, that game is over.  On Sunday, Iowa lost to South Carolina in the finals and the world moves on.  Meanwhile, in the realm of economics, a different debate rages.  Is Federal Reserve policy tight, or not?

Ultimately, there is an ironclad two-part test to determine if monetary policy is tight.  First, has the economy weakened to below trend growth?  More clearly, is GDP falling, or unemployment rising?  And second, has inflation persistently declined.  If those things haven’t happened, it's hard to argue monetary policy has been tight.

At present, we are tracking Real GDP growth at about a 2.0% annual rate in the first quarter, which is close to the long-term average.  This follows all of 2023, and the last two quarters of 2022, where quarterly real economic growth was faster than 2.0% each and every quarter.  At the same time, unemployment remains below 4.0%.  In other words, we haven’t yet had an economic slump consistent with tight money.

For inflation – after dropping from what appears to be a supply-chain induced spike of about 9.0% in mid-2022 – CPI inflation fell to 3.1% in mid-2023.  But lately, CPI inflation has stopped its decline.  We estimate that consumer prices rose 0.3% in March and the Cleveland Fed’s CPI Nowcast currently projects 0.3% for April, as well.  If so, the overall CPI will be up 3.3% in April versus the year prior.

So, both real growth and inflation show little impact from Fed tightening, in spite of many of the traditional measures of monetary policy signaling tightness.  For example, the M2 measure of the money supply peaked in April 2022 and is down 4.3% since.  We haven’t had a drop like that since the early 1930s during the Great Depression.  Yes, the monetary base is up 10.7% in the past year, but unless that base money is converted into M2, it likely has little impact.  Following the 2008-09 financial crisis, quantitative easing didn’t turn into M2 and inflation remained tame…but during COVID, QE did cause M2 to spike, and inflation jumped.

Meanwhile the slope of the yield curve between the target federal funds rate and the 10-year Treasury yield has been inverted since late 2022, a typical sign of tight money.  And while not as clear cut, the federal funds rate has been 2.0 percentage points, or more, above inflation in the past six months.  While we would say these rates are roughly neutral, not really helping or hurting growth, this is a huge change from the 2009-2021 period, when rates were held well below inflation.

Think of it this way: imagine you’re trying to freeze water, at sea level.  A thermometer shows the temperature is 25⁰F and the water isn’t freezing.  Does this mean the laws of chemistry and physics have been repealed?  Of course not!  Any sensible person would think that the thermometer must be broken, or maybe the liquid you’re trying to freeze isn’t water after all.     

Which brings us to one signal of monetary tightness that hasn’t been triggered yet.  History suggests that interest rates should be roughly equal to “nominal” GDP growth (real GDP growth plus inflation) – a cousin to what is called the “Taylor Rule.”  Nominal GDP is up 5.9% in the past year and a 6.5% annual rate in the past two years.  Yet, the federal funds rate is just 5.4%.  That’s not tight money!  Maybe that’s the measure of tightness we should have been following all along.

In other words, maybe one of the reasons we haven’t yet experienced economic turbulence is that monetary policy hasn’t been as tight as most investors thought.  If so, it could take much longer to bring inflation down to 2.0% than the Fed expects, which means short-term rates could stay much higher for much longer.

In turn, that would mean more economic pain ahead than most investors currently expect.  Some calls are hard to make no matter how much time is left in the game.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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