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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As summer settles in, chasing lingering memories of record-setting snowfalls and damaging ice dams, all eyes remain focused firmly on the employment reports and on the Federal Reserve’s reaction to them.

The May report was much stronger than expected. Employers added 280,000 jobs for the month, besting by a large margin April’s ‘not-quite-up-to-expectations ‘ performance and replacing most of the air the dismal (85,000) gain for March had sucked from economic forecasts.

The unemployment rate ticked up slightly (to 5.5 percent) as more people entered the job market and claims for unemployment benefits fell close to a 15-year low at the end of May. But wage gains remained anemic (0.3 percent for May), fueling continuing concern that a “wage-less” recovery will crimp consumer confidence and spending and undermine economic growth.

Interest Rate Watch

The key question – when the Fed will see sufficient strength in the economy to begin raising interest rates – remains unanswered. Until recently, Fed Chairman Janet Yellen has made it clear that, for her, the risks of a premature rate hike that would derail the recovery outweighed the risks that leaving rates too low for too long will trigger a damaging inflationary spiral. The head of the International Monetary Fund recently endorsed that view, urging the Fed to await “more tangible signs” that the economy is overheating before making a rate move.

But in recent comments, Yellen has signaled that her risk assessment has shifted. Following the April employment report (but before the most recent one), Yellen said current economic conditions suggest that it will be “appropriate” for the Fed to begin adjusting interest rates “at some point this year….Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner,” she noted. “Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.”

But Yellen added that while the employment market is “approaching” full strength, “it’s not there yet.” The timing of the Fed’s rate moves will be dictated by economic conditions, she emphasized, and the pace, she said, will be gradual.

“The various headwinds that are still restraining the economy…will likely take some time to fully abate, and the pace of that improvement is highly uncertain,” Yellen said. “If conditions develop as my colleagues and I expect, then the FOMC's objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.”

With key economic indicators still mixed, but generally stronger, some analysts are predicting that the Fed will make its first move in September; others are predicting that continued concerns about economic growth (that 0.7 percent first-quarter declined rattled everyone a little) will stay the Fed’s hand until the end of this year or early next.

Better Positioned Now

But there seems to be a growing consensus that the impact of higher rates, whenever they come, will be muted, because household finances, at least relatively speaking are in decent shape, with debt levels lower and savings rates higher than they were a few years ago. Perhaps most important, homeowners have shifted decisively from adjustable rate to fixed-rate mortgages, leaving homeowners much less vulnerable to rate hikes. Only 18 percent of homeowners with mortgages had ARMs last year, compared with nearly 30 percent a decade ago.

Analysts also think the housing market recovery, while less than robust, is well-established and better able to withstand higher rates than it was two years ago. The Federal Reserve’s ‘Beige Book’ for May reported the housing outlook in most districts “largely positive” with evidence of strengthening demand as the spring market developed.

Existing home sales declined in April by 3.3 percent compared with March, as skimpy inventories thwarted demand in many markets. But sales remained almost 6 percent above the same month a year ago, according to the National Association of Realtors (NAR). And the NAR’s pending sales index– a predictor of future activity – jumped by 3.4 percent, blowing past more modest predictions and reaching its highest level in 9 years.

With real estate agents reporting demand strengthening and foot traffic growing in many areas, the NAR’s chief economist, Lawrence Yun noted in one of his recent reports, “Homeowners looking to sell this spring appear to be in the driver’s seat.”

A New Driver

New home sales more than made up for the dip in the existing home sector, rising 6.8 percent over March (when sales declined sharply) and 26 percent above the year-ago volume. Starts and permits also sparkled, with annualized gains of 20.2 percent and 10.1 percent, respectively, representing the best report in more than 7 years.

Particularly encouraging to industry analysts: The strength was concentrated in the single-family sector rather than in the multi-family area, which has been the primary driver for this sector throughout the recovery. Robert Dietz, vice president of tax and market analysis at the National Association of Home Builders, predicts that new home starts this year will actually surpass multi-family construction for the first time in almost eight years.

“Homebuilding is finally finding its rhythm,” Ryan Sweet, senior economist at Moody’s Analytics Inc., agreed. “With the job market tightening, wages showing subtle signs of improvement, and borrowing costs at historical lows,” he told Bloomberg News, “we should see a solid pickup in the second half.”

New Bubble Fears

Rising home prices nationally reflect the combined effects of increasing demand and anemic inventories. The S&P-Case-Shiller 20-city index jumped another 1 percent in March pushing prices 5 percent ahead year-over-year – the 35th consecutive monthly gain. That trend line is fueling concerns about an emerging housing bubble, which isn’t surprising, David Blitzer, managing director and chairman of the S&P Index Committee, agrees. But he doesn’t think the concerns are justified. The pace of year-over year gains has slowed over the past six months, he noted, and price gains are outpacing income growth, narrowing the pool of eligible buyers.

“All of this suggests that some future moderation in home price gains is likely. I would describe this as a rebound in home prices, not a bullet,” he told Bloomberg, “and not a reason to be fearful.”

Freddie Mac economists generally agree that higher prices haven’t seriously undermined affordability — yet. But they see some cause for concern going forward. Freddie’s May Economic and Housing Outlook notes: “While many markets look highly affordable today, the story can change quickly if interest rates and home prices rise without any offsetting income growth.”