Fed’s High Wire Inflation Fighting Effort Risks Triggering a Recessionary Fall

Imagine a high-wire act performed without a net.  That describes the Federal Reserve’s effort to curb inflation without crashing the economy.  Success will bring applause and relief; failure, a brief downturn, at best, with a prolonged recession the worst case outcome. 

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If you’re tired of predicting who will win the presidential primaries – or who will say what about whom in that process ─ there’s another increasingly popular guessing game you might want to play instead: How many times will the Federal Reserve hike interest rates this year?

Fed officials seemed to answer that question in December when they increased the Fed Funds rate for the first time since 2006, signaling at the time that as many as three additional increases would likely follow this year. But turmoil in the financial markets, triggered largely by the collapse of oil prices and weakness in the European and Chinese economies, have made policy makers less confident than they were last year about the U.S. economy’s ability to absorb higher rates.

Most economists are now predicting that the growth rate won’t get much above 2 percent this year, and some are suggesting that the odds of another recession are increasing. Fannie Mae economists cited “slowing economic growth, worsening global financial conditions and weakening inflation expectations” as their reasons for predicting only two rate hikes this year rather than three.

The February employment report didn’t do much to clarify the outlook. Employers added 242,000 workers to their payrolls, outstripping expectations, but average hourly waged declined for the first time in a year. The unemployment rate remained unchanged at 4.9 percent.

“It indicates the resilience of the economy,” Michael Feroli, chief U.S. economist at JPMorgan Chase, told Bloomberg News. “The labor market doesn’t appear to be hurt by financial market volatility,” he said, but wages, he acknowledged, “were a bit disappointing.” It is wage growth, lacking so far, that policy makers are watching for signs of inflationary pressures that will begin moving the economy closer to the Fed’s inflation targets.

Negative Interest Rates?

Although some analysts are betting the Fed won’t boost rates at all, the consensus forecast anticipates at least one increase, but no more than two. A few analysts are predicting that the Fed will be forced to backtrack in the next year or two, pushing rates again back to zero and possibly into negative territory. Fed Chairman Janet Yellen didn’t dismiss that prospect entirely in recent Congressional testimony, though she did describe it as “unlikely.”

Bill Dudley, president of the Federal Reserve Bank of New York was more emphatic, insisting in a recent speech that negative interest rates aren’t just unlikely, they are unjustified by economic conditions. Concerns about the outlook, he said, overstate the economy’s weaknesses and understate its strengths – primary among them, the housing market.

Lawrence Yun, chief economist for the National Association of Realtors (NAR), agrees that the housing market remains a significant source of strength “and will likely help the U.S. economy avoid a recession.” But that optimistic assessment assumes housing will match or surpass last year’s impressive performance, which, Yun has acknowledged, is less than a foregone conclusion.

His primary worry is the depleted inventory of available homes for sale, which is limiting the choices for would-be buyers, keeping upward pressure on prices and creating bidding wars in some markets. According to one survey, 25 percent of the homes sold in October were purchased by buyers who paid the listing price or more, indicating that buyer demand is outstripping the supply.

“An Uphill Climb”

This is a particular problem for first-time buyers, who “continue to encounter instances where their offer is trumped by cash buyers and investors,” Yun noted in a recent NAR report. “Without a much-needed boost in new and existing-homes for sale in their price range, their path to homeownership will remain an uphill climb,” he warned.

Although appreciation rates have slowed in recent months, home prices are still rising faster than average incomes. The Case-Shiller home price index posted a 5.7 percent year-over year gain in January. “That is good news for homeowners,” Yun acknowledged, giving them an incentive to sell their homes. “But I’m not so sure it’s good for the economy,” he added, noting that the lack of new construction remains a serious and increasing concern.

"The spring buying season is right around the corner and current supply levels aren't even close to what's needed to accommodate the subsequent growth in housing demand," he observed in a recent press release. "Home prices ascending near or above double-digit appreciation aren't healthy,” he added, “especially considering the fact that household income and wages are barely rising."

Despite supply constraints and price pressures, existing home sales eked out a small increase in January, rising 0.4 percent above December and almost 11 percent above the year-ago level. New home sales moved in the opposite direction, however, falling 9.2 percent below December and 5.2 percent below the same month last year.

New home starts also disappointed, posting a 3.8 percent decline instead of the 2 percent increase analysts were expecting and falling to a three-month low. Permits – an indicator of future activity – remained essentially unchanged from December’s 1.02 million annualized rate.

Builder Concerns

Reflecting those negative trends, builder sentiment, measured by a National Association of Home Builders (NAHB) index, also declined in January on concerns about slowing customer traffic and the rising cost of labor. More than three-quarters of the builders responding to the latest survey said they expect the labor problems to become more acute as construction activity increases this spring.

Although the January new home statistics were largely negative, analysts were able to find some positive indicators, two in particular:

  • The 12-month rolling sales total was up almost 12 percent year-over-year; and
  • The number of pre-construction purchases is running at close to a 10-year high – probably reflecting the dearth of existing homes available for sale.

Analysts also pointed out that January is traditionally the slowest month of the year for new home sales, and the statistics, they note, are famously volatile, subject to frequent and often sizable adjustments.

“The series on new home sales is often choppy, but through some of the noise in the data, it appears that home sales are continuing to trend higher over time off of historically low levels,” Daniel Silver , an economist with JPMorgan Chase Bank, observed in a press statement. Given those trends, he said, “We maintain our view that the housing market will continue to recover.”

David Crowe, chief economist for the NAHB, shares his confidence. Notwithstanding the January dip in new home sales, he remains convinced that “the fundamentals are in place for continued growth of the housing market.” Crowe’s prediction: “Historically low mortgage rates, steady job gains, improved household formations and significant pent up demand all point to a gradual upward trend for housing in the year ahead."