Stocks rose yesterday after a favorable CPI report showed inflation slowing. That probably ensured that the Fed will not raise rates again in September. But bond yields rose and equities finished the session well off their highs for the day.
The biggest CPI component, shelter costs, is slowly receding. As we have noted often, there is a measurement lag within the index regarding shelter costs. Both rents and home prices have been rising at slower rates for months. In some geographies, prices have actually fallen. A huge number of new apartments coming on line probably put a cap on rental rates near term. Home prices appear to have stabilized. A return to the frantic buying days of 2021 is now a distant memory. But wages are still rising at a pace a bit too hot for inflation to fall much further in the near-term. Prices for services are more important to any calculation of the rate of inflation than the price of goods. Wages are the largest component of services costs. Thus, while the Fed may be near the end of its rate hiking cycle, the notion that a series of rapid cuts in the Fed Funds rate is near is probably overly optimistic.
This morning, I want to step back and look away from near-term numbers. I want to look at a world that might be considered normal, one where central banks get off their collective roller coasters of monetary easing and tightening, one that allows market forces to dictate economic direction. Easy money is enjoyable while it happens. Who doesn’t like collecting dollars dropped out of helicopters? Money is the engine of growth. More money equals more growth. But as we have seen, it also means inflation and other unintended consequences. Tightening usually follows. That stops inflation but it also stops growth.
What works best is balance, a world where supply and demand grow at roughly the same rate. In this world, wages rise slightly faster than inflation, offering workers real gains. Inflation is avoided by productivity gains. Thus, the long-term growth engines of any economy are the increase in the size of the workforce and productivity improvements.
The growth in the size of the workforce is a function of birth rates, death rates, and immigration. In 2022, roughly a million immigrants entered the U.S. This does not include all the illegal immigrants that gather all the media attention. Mexico is the largest source of immigrants to the U.S. That should come as no surprise given it is our neighbor and the obvious fact that economic opportunity here is greater than in Mexico. A close second was India with China a distant third. Net immigration adds about 0.3% to our population, perhaps a slightly higher number to the work force. Birth rates in the U.S. have been declining as population has aged. In addition, mortality has deteriorated the past few years partly related to Covid. Add the three together, and the demographic growth is likely to be about 0.6% from population. That may seem small but compared to the rest of the developed world, it’s outstanding. Japan has been in decline for years as have many European nations. China is starting to decline as well, a product of its long time one birth per family policy, as well as the lack of a safety net (pensions and health care) for the aged.
Productivity bounces around, largely impacted by short-term economic cycles, but long-term, there is a steady average close to 1.5%. To move that needle takes a major wave of inventions. The emergence of the automobile, or airlines about a century ago, are two examples that moved the needle. Long-term evolutionary trends like robotics certainly help but there isn’t a surge in any one year. Perhaps autonomous vehicles someday will make a measurable difference. But that is still in the future. Add the 1.5% productivity to 0.6% population growth and you arrive at a sustainable real rate of growth of about 2%. Add inflation and the nominal sustainable growth rate is about 4%.
Politicians sometimes feel they can somehow goose that number higher via legislation. As noted Monday, so far this fiscal year, Federal outlays have risen 11%. President Biden, in his latest budget proposal, has a long laundry list of pet programs he would like to fund on top of what has already been passed. Indeed, government spending today is at its highest level as a percentage of GDP than at any time since the end of World War II. But as we have learned so often, when Washington spending gets out of control, inflation is sure to follow. That is one reason the Fed will have to keep rates higher for longer.
But back to the long-term. When interest rates are far removed from the sustained pace of inflation, bad things happen. When rates are too low and money becomes free in real terms, individuals and businesses make careless and often irrational decisions. The surfeit of zombie shopping centers and empty office buildings are not just due to Covid. WeWork got a lot of media attention renting office space on a short-term basis to entrepreneurs. But matching short-term rental revenue to long-term lease obligations doesn’t work so well when times get tough and debt service costs rise. A mismatch like that is inevitable. It all evolved out of an era of cheap money and excessive speculation. Conversely, when rates are too high, activity slows and financial defaults increase.
In simple terms, as the old ad said, “It’s not nice to fool Mother Nature.” Excess stimulus always leads to eventual tightening. That doesn’t mean Fed intervention isn’t needed at times of crisis. But one has to recognize that putting the lid on the cookie jar isn’t easy once you introduce all to the sugar high.
With all this said, it does appear that current Federal Reserve leadership would like to step back, return to balance once inflation has been contained, and let market forces dominate future economic trends. At least that’s the verbiage you hear today. We will see once the Fed starts to cut rates, whether they can get to neutral and get out of the way.
But, let’s suppose they do. What does that world look like? If we assume demographics and productivity lead to 2% real growth, the future Fed Funds rate should stabilize somewhat higher. A real cost to money is needed to lessen the use of stupid pills in making economic decisions. Long-term rates need to be higher; lenders accept more risk as duration lengthens. Long rates also need to reflect inflation. Thus, they would be measured more against nominal growth rates of GDP suggesting a stabilized 10-year Treasury yield of 4% or so. History also shows that bonds generally have been priced to a real return higher than 2%. That premium has been less so far this century. However, for most of the 21st century, central banks have been aggressively easing monetary conditions.
A return to normal would lead to an environment similar to most of the post-World War II period during the 20th century excluding the hyper-inflationary times in the 1970s when monetary policy was excessively expansionary. It took strong actions from Paul Volcker and, later, an even hand from Alan Greenspan to settle markets once again.
An era of low-single digit Federal Funds rates, and slow steady GDP growth led to the longest sustained bull market in memory, one that spanned almost two decades in the 1980s and 1990s. In equity markets, there were periods of excessive speculation (1987 comes to mind), and occasional bear markets. But in a world of economic balance, the damage was short-lived. We didn’t need 3% mortgages to support a housing boom. Technology advanced without free money. The 80s and 90s saw the birth of personal computers and the Internet. But in a world with a real cost of money, and nominal long term interest rates either side of 5%, few stocks sold at over 20 times forward earnings. When that did happen, markets corrected. Nvidia may be the greatest chip company in the world and Eli Lilly may have the new wonder drug that helps weight loss and reduces the risk of heart attacks. But these stocks sell at 18-40x sales and 50-80x projected earnings. Neither will lack for competition in the years ahead. Both are priced for perfection. Can they meet those expectations? Future earnings may turn out to be even higher than the most bullish investors believe today. But both face competition and there are always speed bumps down the road. No wonder many tech leaders are giving back part of their earlier gains.
Corrections are always healthy. They are natural. The Fed’s job is to create balance and then get out of the way only making modest mid-course corrections as necessary. If this Fed stays true to plan, good times may lie ahead. It would be helpful if Congress acted more rationally. It already spends one out of every four dollars in this country. Not long ago it was one out of five. Are we ready for a world where it spends one out of three? To do so would require massive increases in revenues. I’ll stop there.
The bottom line is real interest rates aren’t to be feared. They are to be welcomed. They foster consistent growth. When the battle against inflation is complete there is no reason not to expect the Fed Funds rate to retreat toward 3% over time. But anything lower invites distortion. After years on the monetary roller coaster, wouldn’t be nice to have a smooth level ride.
Today, Hulk Hogan is 70. Steve Wozniak, Apple’s co-founder, is 73.
James M. Meyer, CFA 610-260-2220