Viewpoints

The Fed raised official rates by 500 basis points from 2022 to 2023, the most significant increase over forty years, and there was no recession. The Treasury yield curve inverted for almost two years, and there was no recession. Is it time to rethink what constitutes tight financial conditions? Merely measuring financial conditions based on interest rate levels is insufficient nowadays when monetary and fiscal policies add trillions to the economy via asset purchases and budget deficits.

The traditional perspective on stringent financial conditions involves official rates higher than reported inflation, an economy expanding below its capacity, an unemployment rate significantly exceeding estimated full employment, and stagnant real and financial asset values, with the possibility of notable declines in either or both.

Yet today's economic and financial picture is the exact opposite—the economy is growing above trend, the unemployment rate is close to the full employment mark, and asset prices are at record levels.

Given these economic and financial outcomes, it becomes clear that a reassessment of our monetary and fiscal policies is necessary to better understand and explain tight financial conditions. This could explain why the current economic and financial situation differs significantly from past years.

Firstly, it's crucial to note that the Federal Reserve's balance sheet remains substantial, at close to $7 trillion. This is approximately $4 trillion higher than its level four years ago. While the Fed's balance sheet is no longer expanding and is gradually shrinking, its impact on financial markets should not be underestimated. The additional $4 trillion of Fed security holdings equates to $4 trillion of liquidity for private investors seeking other investment opportunities.

Second, the US budget deficit is running at about $1.9 trillion. Not every dollar of government spending shows up in GDP, but what does not goes into the hands of people and businesses, and their spending does show up. Also, when the government runs a deficit, it means that people and businesses are not being taxed to an equal amount for the level of government spending. So, the bottom line is that budget deficits enable people's and businesses' cash flow to be higher than otherwise would be the case.

The Fed's balance sheet and the Federal government deficit together amount to over 30% of nominal GDP, which is enormous. The only times it was larger were during the pandemic years.

Using interest rate levels as the traditional method to gauge tight financial conditions is no longer relevant. The current unprecedented stimulus from monetary policy, achieved through asset purchases, and from fiscal policy, due to a relatively large budget deficit, makes it difficult to determine what defines tight financial conditions. It is challenging to ascertain if financial conditions are tight until the combined stimulus falls below pre-pandemic levels (or well below 20% of Nominal GDP).

The Yale Environmental Performance Index (EPI) 2024 Report states that there is a positive correlation between a country’s living standards and its progress toward achieving environmental goals. We wanted to explore that relationship in hopes of both shedding light on paths to making further progress toward environmental sustainability and highlighting any roadblocks. As Brookings noted in its commentary, “Developing Countries are Key to Climate Action,” it is imperative that any solutions for global climate change take into consideration the competing goal of increasing living standards in developing nations.

We ran regressions on 175 countries in cross section to quantify how living standards (as measured by 2023 per capita GDP) affect progress on environmental issues (as measured by the 2024 EPI). From these data, we can verify that per capita GDP is strongly correlated with EPI scores. Like the Yale study, we noticed that the gains from higher per capita GDP diminish as nations become wealthier. We were able to model this by taking logs of per capita income. As the chart shows, an increase in per capita GDP from 4 to 5 ($10,000 to $100,000) is associated with an increase of 15 points in the overall EPI score. The goodness of fit (adjusted R2) for this regression is 60.4 percent.

The ratio of the home price to median household income has nearly doubled since 2000. It's counterfactual to think that would have occurred if the BLS (Bureau of Labor Statistics) had not changed in 1999 its survey of owner-occupied housing to measure implicit owner-rents. Unbeknownst to many, the change has led to a significant undercount of housing and overall CPI inflation for decades.

In 1999, BLS made a significant change by 'simplifying the housing survey' to measure owners-rents in the CPI. It no longer tracked two types of housing units, owners and renters, with different characteristics and, in many cases, various locations. BLS argued that this change was necessary because it could no longer find an adequate sample of owner-occupied units for rent. BLS stated that the change was made to ensure the accuracy of the data, but the actual outcome was an understatement of housing inflation and overall inflation.

During the housing boom of the early 2000s, a crucial period that underscored the importance of accurate inflation data, I debated with BLS at an annual economic conference in 2004. Our research found that the rental survey underestimated actual or experienced inflation by several hundred basis points each year in the owner-occupied housing market. My main point was that the owner and rental markets were two distinct housing markets with different vacancy rates, and the latter was a primary determinant of rent changes.

BLS countered, stating, "There is no clear theoretical relationship between the homeowner vacancy rate and owners' equivalent rent." I emphasized that the practical relationship states otherwise. When housing prices are rising rapidly, and there is a short supply of housing units, why would owner-rents track the rental market and not the owner-housing market? Different markets yield different inflation.

This practical relationship, often overlooked, is crucial to understanding the actual inflation rates in the owner housing market. During the housing boom of the early 2000s, owners' rents increased between 2% and 3% per year, as they were linked statistically to rents of primary residences, while house prices rose at double-digit rates. Even today, owners' rents are not tracking house price inflation.

Many factors are behind house price inflation. Yet, if consumer price inflation tracked actual house price inflation versus a "hypothetical measure," it is hard to argue against the view the fact that overall inflation would not be higher, as official and market interest rates would be as well, resulting in a median house price much below current levels.

The change in the housing rent survey is a much more significant BLS blunder than the recent controversy over the overstatement of payroll job growth, as it affects reported inflation, inflation adjustments to entitlement programs, and, in some cases, workers' wages and official and market interest rates.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in July were soft. Connecticut was (again) on top with a .8 percent gain from June, but Alabama was the only other state with an increase of as much as .5 percent. A full 22 states saw declines, led by a plunge of 1 percent in Massachusetts (suggesting that the Hartford-Springfield MSA performance was near zero?). And, over the 3 months ending in July, 14 states were down, with Massachusetts off 1.5 percent, and Missouri and Montana seeing 1 percent drops. Connecticut was also on top at this horizon, with an increase of 2.2 percent (clearly, something odd must be happening around the intersection of I-84 and the Mass Pike…). Over the last 12 months, 6 states were down, and another 7 saw increases of less than 1 percent. Continuing the New England focus, Rhode Island’s index was off 1.7 percent. Arizona had a 4.6 percent increase, and 4 other states—mainly in the west—had gains of 3 percent or more.

The independently estimated national estimate of growth over the last 3 months (.4 percent) seems a bit lower than the state figures would suggest, but the 12-month result (2.4 percent) looks to be roughly in line with the state numbers.

State labor markets were generally soft in July. New York and Oregon were the only state with statistically significant gains in payrolls—and roughly ¾ of New York’s seemingly large 41,000 gain was due to a clearly aberrant surge in government employment. Missouri large .7 percent drop (22,400) was the sole statistically significant decline, but numbers of other states reported point drops.

Thirteen states had statistically significant increases in their unemployment rates in July and one (Connecticut) showed a decline. Massachusetts, Michigan, Minnesota, and South Carolina all registered increases of .3 percentage points. The highest unemployment rates were in DC (5.5%), Nevada (5.4%), California (5.2%), and Illinois (5.2%). No other state had rates as much as a point higher than the national 4.1%. Alabama, Hawaii, Iowa, Maine, Maryland, Mississippi, Nebraska, New Hampshire, North Dakota, South Dakota, Vermont, Virginia, and Wyoming had rates of 3.0% or lower, with South Dakota at 2.0%.

Puerto Rico’s unemployment rate was unchanged at 5.8%, while the island’s job count fell by 2,100.

History shows that US growth cycles don't die of old age but are "murdered by the Federal Reserve." Then why has the most significant, in terms of scale, Fed tightening cycle of the past forty years not "murdered" the current growth cycle? The question is complex and challenging to answer, involving many factors. Still, monetary and fiscal policy roles are central to the current growth cycle, making this a compelling study area for analysts and policymakers.

Monetary Policy

The Fed's 500 basis point tightening cycle from 2022 to 2023 stands out as the most significant in scale over the past forty years, surpassing the previous four cycles, which ranged from 175 to 350 basis points. Notably, three of the prior tightening cycles ended in recession, with the 1994-95 cycle being the exception. This time, the economy avoided recession and experienced a growth of over three percent following the Fed's cessation of official rate hikes.

So, has the role of monetary policy in impacting growth cycles changed, or is the policy stance not restrictive to "murder" a growth cycle? The latter.

First, history shows that restrictive monetary policy occurs when official rates are well above the inflation rate. The Fed hiking cycle started with official rates near zero, far below the inflation rate. It wasn't until the middle of 2023, more than a year after the Fed started hiking rates, that official rates matched and then began to exceed what is reported nowadays as consumer inflation.

Yet, it is worth noting that a recent study by economists at Harvard and the IMF found that if inflation was still measured the "old way" (i.e., which included financing costs), reported inflation would have been in the mid-to-high teens. Monetary policy may not be restrictive if actual or experienced inflation is higher than reported. The Harvard and IMF study did not include house prices in its findings as the old CPI did. If house prices replace owners' rents, which are not actual prices, the current reported inflation is still far below actual or experienced inflation.

Economists have developed numerous rules or indicators, such as the Sahm rule and yield curve, to gauge the risk of recession associated with a restrictive monetary policy. However, the housing starts rule stands out for its consistent reliability. It has always succeeded in signaling a tight monetary policy and an impending recession. A substantial decline in housing starts has consistently preceded every recession, and so far, housing starts have not shown a decline associated with stringent monetary conditions. This underscores the importance of considering multiple indicators in economic analysis.

The new tool of quantitative easing is another factor that needs to be considered in the overall stance of monetary policy. Based on the 'stock effect' of quantitative easing, which former Fed Chair Ben Bernanke said is more powerful than the flow effect, QE has offset a significant chunk of official rate hikes, as the Fed balance sheet is still twice the size it was before the pandemic. This underscores the complexity of analyzing the current stance of monetary policy, as the scale of QE needs to be considered.

Fiscal Policy

Fiscal policy is another critical factor when analyzing the current economic cycle. Every dollar the federal government spends goes into someone's pocket, whether a consumer or a business.

The federal government is running a deficit of 6% of nominal GDP. Deficits of that magnitude are rare, occurring during the depth of the recession and never during an economic growth cycle.

When the federal government runs a deficit, it's comparable to when the consumer borrows money to spend beyond its income. Yet, federal government spending is not sensitive to interest rates as it merely borrows more to fund the excess expenditures.

The stance of fiscal policy will only change in two ways: first, if there is legislative action to reduce the pace of spending, or second, if there is a change in tax law requiring consumers and businesses to pay more in taxes to fund the higher spending. Given the 2024 elections are three months away, Congress will not pass any significant spending or tax legislation. And with a new administration taking office in early 2025, it is unlikely that there will be any fiscal restraint anytime soon. The earliest there could be a significant change in fiscal policy stance is when the 2017 tax cuts expire at the end of 2025.

So, when the next recession occurs, it will still be "Made in Washington." However, for now, the combined monetary and fiscal stance policies are too stimulative for a recession to occur and are likely to become even more so if the Fed decides to ease in September.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in June were mixed. Connecticut saw a robust increase of 1.1 percent from May, and Maine rose .7 percent. However, 14 states registered declines, with Massachusetts off nearly .5 percent (obviously some diversity in the performance of New England states!). Over the three months since March, 9 states had increases of more than 1 percent, with Montana up 2.1 percent, but 9 had no change or declines over that period, led by Kansas’s .65 percent drop. The diversity in New England, now localized on the north shore of Long Island Sound, was also evident at this frequency, with Connecticut up 1.9 percent and Rhode Island down .2 percent. Over the last 12 months, Arizona saw an increase of 4.3 percent, with 7 other states up more than 3 percent. However, a full dozen states had growth under 1 percent, and 5 of those saw declines, led by Rhode Island’s 1.2 percent drop.

The independently estimated national figures of growth over the last 3 (.6 percent) and 12 (2.7 percent) months appear to be roughly in line with the state numbers.

State labor markets were yet again mixed to moderate in June, though the number of states with unemployment rates under 3.0% diminished. Eight states had statistically significant gains in payrolls, all in the range of .4 to .6 percent. North Carolina’s increase of 23,100 (.5 percent) was the largest, though California’s statistically insignificant rise of 22,500 was nearly as big.

Eight states had statistically significant increases in their unemployment rates in June and one showed a decline. The increases were no more than .2 percentage point, but Connecticut’s rate dropped .4 percentage points to 3.9%. The highest unemployment rates were in DC (5.4%), California (5.2%), Nevada (5.2%), and Illinois (5.0%). No other state had rates as much as a point higher than the national 4.1%. Alabama, Hawaii, Iowa, Maine, Maryland, Minnesota, Mississippi, Nebraska, New Hampshire, North Dakota, South Dakota, Tennessee, Vermont, Virginia, Wisconsin, and Wyoming had rates of 3.0% or lower, with both South Dakota at 2.0%.

Puerto Rico’s unemployment rate was unchanged at 5.8%, while the island’s job count fell by 900.