Why More Rate Hikes Won’t Help

A couple weeks ago, Jerome Powell kicked off a party by pausing rate hikes. Then ruined it a half hour later.

His vision is to limit Personal Consumption Expenditures (PCE) below 2% annual growth. Insisting that inflation is still too high dampened traders’ moods.

You would think that going from 7% to just under 4% this May was a significant accomplishment. Who knows…the market could sort out the rest on its own?

I mean, producer prices are dropping like stones. Buyers started holding out for a better deal and sellers need to move product.

But PCE as a whole isn’t good enough for the Fed. The “core,” which ignores food and energy spend, is too sticky. So the Fed keeps pushing the base interest rate higher thinking the same tool will push down prices more.

But have we passed the point where this has any more benefit? Or are we on the cusp of the breaking point?

Gimme shelter…for less

For background, Core PCE tracks services and goods that don’t fluctuate as wildly as food and energy. The stickiest part right now is the cost of shelter.

Think about what’s putting the roof over your head right now. Everything had to be built. And to build it, the builder likely financed all the materials. Which interest rates heavily influence.

On the other side, people switch houses in relatively stable markets. Kind of like the one we had from 2011-2020.

Kids graduate school and need a new place near their job. People having kids need more living space. And empty nesters don’t need so much space anymore. People are moving all the time.

New housing inventory helps with these shifts in society. Some families can afford building a custom home. Others settle for a speculative home at a lower price in a new or established neighborhood.

As long as there are enough units for people to move into, prices are content.

Out of Balance

But when the market gets a shock, like it did in 2020, these factors fly out of balance. Many areas of the US looked more appealing than others. So people moved there.

This influx drove property values higher. It didn’t matter much for the folks moving to much cheaper areas from more expensive ones. So higher the values went.

And when interest rates rose, people who really wanted a house had no incentive to buy one. Those in existing homes wouldn’t leave their rock-bottom interest rate mortgages, either.

The other thing working against falling prices? A 5 million housing unit shortage. But, as it stands, the only way for more inventory to come on the market is to build it.

So if it costs more for builders to finance their building materials…

And they can’t put up enough roofs over people’s heads…

And if there aren’t enough houses at the right prices to fill demand…

What happens to that sticky part of the Core PCE?

Oh, right…it goes up again.

No, really, housing is different

This isn’t like food prices. They skyrocketed after a territorial dispute in Eastern Europe. Burning 100+ processing plants stateside didn’t help, either. But the political pressure of expensive groceries saw a quick turnaround in prices at the shelves.

Nor like oil prices. People stopped driving and drillers stopped drilling. Then had to catch back up as people went back to their normal lives.

Housing is different. Prices, savings levels, financing, availability, and sentiment all have to work for the home buyer to get the housing part of Core PCE within range. There aren’t a lot of alternatives.

They could try moving into apartments. Except the 5-million unit shortage includes those. Apartment projects are stuck in the same financing dilemma as homebuilders.

But apartment owners have continuing operations. And labor and materials are getting more expensive. They have to raise rents to keep up with rising costs. Eventually, more tenants will trade down or move out.

If that weren’t enough, a slew of apartments are due for refinancing in the next 5 years. Owners are looking at interest rates double what they have now.

Which would distress those higher-priced apartments and reset their values. Sounds like what those once-hot office districts are going through right now.

Not like the banks backing those loans had anything to worry about this year.

So it begs the question: is the Fed working to return inflation to their normal 2% expectation? Or are they working to reset asset values?

Let the market do its thing

Housing prices will fall on their own. More supply is coming on the market to close that gap of 5 million units.

And most homeowners won’t have the patience to pay on a low-rate mortgage for the next 30 years. Because life.

We’re already seeing these price drops pan out in industry. And higher demand should benefit these companies’ recent investments to make more stuff. It’s safe to say the Fed has threaded the needle up to this point.

All higher rates will do at this point is push more people off the financial cliff. It will certainly cause a drastic price reset and curtail inflation. But are we prepared for that much pain?

The worst case should be companies having to sell at lower prices to attract customers. It’s not a great growth prospect, but it doesn’t hurt like a crash.

With even higher rates, the worst case could be breaking the back of the economy. Not just inflation.

I mean, if the Fed is so concerned with how inflation affects the poorest, should it be this obvious how their policies pick winners?

When values crash, it’s the large, established resource pools scooping up property at rock bottom prices. Not the people who need affordable shelter.

It’s time to hold rates where they are and let the market continue negotiating prices downward. Otherwise, a lot of other things will have to break before we see a break in shelter costs.

No one likes that kind of party.

How are higher interest rates affecting your small business? Leave me a comment below.

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