Why Did Fed Raise Rates Again?

Popular Economics Weekly

U.S. growth cycles have averaged about 8 years since WWII, yet the Federal Reserve just announced they were raising their overnight rate for the third time—to 1.25 percent. It also forecast that the unemployment rate could fall further, and economic growth continue for another one to two years, before the inevitable downturn.

What is the basis for their very optimistic prognosis with this growth cycle already 8 years old, and as Goldman Sachs economist Jan Hatzius says 8 years has been the average length of recoveries since WWII? We have a 4.3 percent unemployment rate, and one million fewer workers were hired (5 million in May) than the number of job openings (6 million) in the Labor Department’s latest JOLTS report, so what comes next?

Graph: Hatzius-Goldman Sachs

Fed Chair Yellen said that because of the tight labor market, price pressures are more likely to intensify. The unemployment rate fell in May to a 16-year low of 4.3 percent amid widespread reports that businesses are running out of qualified workers to hire, as I said.

In some cases, firms have sharply boosted pay to attract or retain workers, and the Fed believes that is always a red flag for incipient inflation. “Conditions are in place for inflation to move up,” Yellen said in a press conference after the Fed action.

But inflation is nowhere in sight, nor are wages on average rising more than 2.5 percent, still to low to boost economic activity. The May Consumer Price Index was basically unchanged, which may be why retail sales fell in May, but are still rising some 5 percent. Retail sales aren’t corrected for inflation, so when prices fall, it can affect retail sales.

The annual CPI core rate without volatile food and energy prices is just 1.7 percent. The Fed just can’t seem to boost inflation, no matter how hard it tries to talk it up, so it has announced it will begin to sell its $4.5 billion cache of Treasury securities that were accumulated during the various Quantitative Easing programs that have driven interest rates to historic lows. The ten-year bond yield had sunk to an unheard of 2.11 percent, which is why mortgage rates are still at historic lows.

Republicans seem to want to improve the chances of another Great Recession with their passage of the Choice Act that rolls back all the Dodd-Frank regulations that are designed to prevent another Great Recession.

The New York Times just reported on its passage in the House last Thursday, “…a sweeping deregulation of the financial sector. It passed 233-186, with no Democratic support. One Republican, Walter Jones of North Carolina, voted no. This bill rolls back or weakens most of the protections put in place since the 2008 financial crisis through President Barack Obama’s Dodd-Frank Act.”

In their attempts to please Wall Street (how quickly they changed their tune once in power), they are doing everything in their power to remove any oversight, even putting the consumers main protection, the Consumer Financial Protection Bureau, back into the hands of those regulators that allowed the Bush era excesses to happen by looking the other way.

In their purview, the Lehman Brothers failure that started the panic and consequent Great Recession was “market cleansing”. Republicans are saying someone should be punished for the excesses, rather than those excesses be prevented with regulation, and it has to stockholders and homeowners (Lehman had funded all those liar loans without adequate collateral), rather than the banks which were bailed out by the Bush administration’s TARP program, and are now bigger than ever. So what happened to Too Big To Fail?

So the Federal Reserve seems to be operating in its own bubble of unreality. It is anticipating higher growth and inflation, whereas there are no signs of either. Or, it could be anticipating another downturn, and wants to be prepared for it by clearing out its portfolio of bonds. But in selling those bonds into the open market it will surely raise long term bond rates, and mortgages.

But in pushing up interest rates, it could in fact create the slowdown it seems to believe is about to happen.

Harlan Green © 2017

Follow Harlan Green on Twitter: https://twitter.com/HarlanGreen

More Jobs Available, Goldman Upgrades RE Forecast

Popular Economics Weekly

Goldman Sachs economist David Mericle in his research report, “Housing: The Recovery Resumes” says that overall, the message from the broad housing data flow is that the housing market is still at the beginning of a new growth cycle. Real residential investment grew at an 8.8 percent rate in Q2 and is tracking at nearly 15 percent in Q3.

“We continue to see substantial upside for the housing sector in the long run,” said Mericle. “This view is driven by the large gap between the current annual run rate of housing starts, which have averaged about 1 million over the last three months, and our housing analysts' projection of a long-run equilibrium demand for new homes of about 1.5-1.6 million per year, estimated as the sum of trend household formation and demolition of existing homes.”

Trend household formation has been down since 2008. Given the current size of the adult population as well as current headship rates by age or race/ethnicity, the Harvard Joint Center for Housing Studies estimates that demographic trends alone will push household growth in 2015-25 somewhere between 11.6 million and 13.2 million, depending on foreign immigration. This pace of growth is in line with annual averages in the 1980s, 1990s, and 2000s, and should therefore support similar levels of housing construction as in those decades.

Part of the reason for Goldman’s optimism is the millennial generation of echo boomers, children of baby boomers, are beginning to leave home in larger numbers after being held back by the severity of the Great Recession and busted housing bubble. And they are the largest generation born from 1980 to 1996, outnumbering even their baby boomer parents.

More good news is the jobs picture is getting better. Tuesday’s JOLTS report (Job Openings and Labor Turnover Survey) said Jobs Openings rose to 4.8 million in August, up 23 percent year-over-year. The following Calculated Risk graph shows job openings (yellow line), hires (dark blue), Layoff, Discharges and other (red column), and Quits (light blue column) from the JOLTS report.

Graph: Calculated Risk

The number of job openings (yellow) are up 23 percent year-over-year compared to August 2013 and the highest since January 2001. Quits are up 5 percent year-over-year. These are voluntary separations. (see light blue columns at bottom of graph for trend for "quits"), and mean more workers are leaving for better jobs, which means they see better job prospects.

It is a good sign that job openings are over 4 million for the seventh consecutive month - and the highest since January 2001 - and that quits are increasing year-over-year, says Calculated Risk.

So these are good omens for a better housing market. The main problem seems to be supply, and the need for new-home starts that surpass the current 1 million average, thereby boosting new-home sales. But that will depend in large part on those millennials continuing to leave home.

Harlan Green © 2014

Follow Harlan Green on Twitter: https://twitter.com/HarlanGreen

Pending Home Sales Remain Strong

The Mortgage Corner

The Pending Home Sales Index, a forward-looking indicator based on contract signings, declined 1.1 percent to 102.7 in June from 103.8 in May, and is 7.3 percent below June 2013 (110.8), reports the National Association of Realtors. Despite June’s decrease, the index is above 100 – considered an average level of contract activity – for the second consecutive month after failing to reach the mark since November 2013 (100.7).

Lawrence Yun, NAR chief economist, says the housing market is stabilizing, but ongoing challenges are impeding full sales potential. “Activity is notably higher than earlier this year as prices have moderated and inventory levels have improved,” he said. “However, supply shortages still exist in parts of the country, wages are flat, and tight credit conditions are deterring a higher number of potential buyers from fully taking advantage of lower interest rates.”

We also have to look at the newest generation for those potential buyers, the Millennials, or echo boomer children of the baby boomers born after 1980. From ages 18 to 36, they could number as much as 80 million, according to Barron’s Magazine. And this could ultimately generate a huge pent up demand for housing, according to Goldman Sachs analyst Hui Shan.

The fact is more than 35 percent of so-called young adults still live with their parents. It’s in part because of the recession, but also because record numbers have remained in school. Whereas the normal percentage of young adults remaining with parents is about 25 percent, so that extra 10 percent should eventually find their own housing.

"As long as economic recovery and labor market improvements continue, household formation should eventually normalize," Shan writes. "Given the severe damage caused by housing busts to the economy, the process of normalization may take a number of years."

Past history also tells us that new-household formation will pick up, says Shan. "The average household size increased during the first few years of each housing bust, presumably driven by young individuals living with their parents and roommates doubling up to save rent. Over time, the effect reversed itself and average household size retraced the earlier increases, translating into increases in household formation.”

What is normal household formation? It has averaged more than 1 million per year over past decades, but today is somewhere between 350 to 600,000/year, depending on whom you ask. The Harvard Joint Center For Housing Studies predicts it will rise to some 1.2 million annually over the next decade precisely because of Millennials coming of age.

Given the sheer volume of young adults coming of age, the number of households in their 30s should increase by 2.7 million over the coming decade, which should boost demand for new housing. “Ultimately, the large millennial generation will make their presence felt in the owner-occupied market,” says Daniel McCue, research manager of the Joint Center, “just as they already have in the rental market, where demand is strong, rents are rising, construction is robust, and property values increased by double digits for the fourth consecutive year in 2013.”

So despite these headwinds, the NAR’s Yun ultimately expects a slight uptick in pending, and existing-home sales during the second half of the year. Price appreciation has decreased to its slowest pace since March 2012 behind larger increases in inventory, and rents are rising 4 percent annually. So those potential buyers are less likely to experience sticker shock, which makes it more likely that many will choose to buy in order to participate in potential price appreciation, rather than tolerate greater rent increases.

Harlan Green © 2014

Follow Harlan Green on Twitter: https://twitter.com/HarlanGreen

Will Volcker Rule Change Wall Street?

Financial FAQs

Paul Volcker, former Fed Chairman under Presidents Carter and Reagan and economic advisor to President Obama, has at 83 years of age coined a new term, the “Volcker Rule”. It is in the form of findings by the Financial Stability Oversight Council, set up under the Dodd-Frank Bill to consider rules that will rein in Wall Street’s speculative activity that was the main cause of the Great Recession.

The statute seeks to make explicit what types of proprietary trading will be permitted, but the section is open to interpretation by bank regulators. A key issue for regulators is whether they can identify whether a bank made a trade on behalf of a customer, which is permissible, or for its own account, which is not, says CBS Marketwatch.

Why such a need? Because congressional testimony revealed that traders such as Goldman Sachs regularly played both sides of a ‘bet’—i.e., order by clients to buy or sell an asset. They would tout the benefits of an investment to clients, while its own traders in many cases knew it was “crap”, and then bet against that same investment by shorting or otherwise taking out insurance that paid off if the investment failed.

That was particularly true with subprime mortgages, where its traders knew the default rates would be high, and its bond ratings not really the AAA ratings given by the likes of Moody’s and S&P. We now know Goldman Sachs and others made $ billions on such bets that those investments would fail.

The findings also recommended that banks do not own hedge funds or other financial entities that do high risk trading, and that chief executives attest to the effectiveness of their internal compliance efforts to enforce the Volcker Rules.

How liable were commercial banks and investment banks such as Goldman Sachs for the Great Recession, whose initial cause was the busted housing bubble? Subprime mortgages were only a small part of the problem, and real estate in general never made up more than 7 percent of economic activity. But the tremendous amount of overinvestment in housing—1 to 2 million per year were built in excess of actual demand—was multiplied by the unregulated derivatives’ markets that sought to profit from the artificial demand created by so much housing speculation.

And banks became so enamored with what they considered foolproof investments—housing prices had never actually dropped since WWII, and the mortgages backed by them were insured not to fail. Problem was that it was all borrowed money—even the insurance that backed those mortgages. And so the bubbles burst—first housing, then stocks, then the credit house of cards that supported them.

Was there actual criminal behavior that caused the house of cards to collapse? Of course, since derivatives’ traders in particular had a fiduciary duty to their clients to tell the truth, and avoid the conflicts of interest inherent in representing both their clients and their employers. Both are prosecutable offenses and fraudulent behavior.

But it is up to the Justice Department and SEC to prosecute them. Their actions are documented in the 500 plus page report and many accompanying pages of testimony by those involved. There are also tremendous damages documented in the report, which means injured parties can sue in civil courts as well. But we hope the Justice Department will lead the charge with criminal charges. Otherwise it will be business as usual on Wall Street.  If only civil penalties are levied, stockholders will again be picking up the tab.

Harlan Green © 2010

Why Financial Reform?

Financial FAQs

It is becoming clearer that economic self-interest under the guise of trickle-down economics no longer rules in the debate over financial market regulation. There must be regulations that protect the self from itself, and the predatory behavior of others. The SEC’s charge that Goldman Sachs committed fraud in marketing Collateralized Debt Obligation insurance on the worst of subprime mortgage pools is the opening salvo in a campaign to make the players who almost drove financial markets over the cliff responsible for their deeds.

“The SEC suit again Goldman, if proven true, will confirm to people their suspicions about the total selfishness of these financial institutions,” said Wall Street historian Steve Fraser, as quoted in the New York Times. “This is way beyond recklessness. This is way beyond incompetence. This is cynical, selfish exploiting.”

Even President Bill Clinton said recently on ABC’s “This Week” that had he known the damage that unregulated derivatives could wreak on an unsophisticated public as well as sophisticated investors, he would never have backed the 1999 legislation that deregulated them. “I have said many times since then, I made a mistake.”

And even economists are beginning to see the light. A Cambridge, U.K. conference sponsored by currency trader George Soros is looking for other systems that might take us away from economic self-interest. Britain’s chief regulator said, "We need a fundamental challenge to recent conventional wisdom…a dominant conventional wisdom that markets were always rational and self-equilibrating."

Some of the difficulty in pinning down responsibility has been misconceptions about a capitalist economy, said 2001 Nobelist George Akerlof. There is always an element of ‘snake oil’ in all financial markets, which tend to be overlooked even by regulators. What is overlooked is their agenda, such as the ratings’ agencies underestimation of risk, or regulators’ inability to spot a Bernie Madoff. Regulators such as the SEC were either too overworked, or too unsophisticated in not looking under the covers of many offerings. And rating agencies were paid by the companies issuing the securities, hence tended to soften their risk analysis so that even some subprime-based securities were rated AAA.

Secondly, no one seemed to even understand the consequences. A string of unprecedented financial innovations created institutions that “don’t take into account the kind of communities we want to build”, said economist Robert Shiller in a recent New York Times Op-ed. Yet as leaders of their respective institutions it was certainly their job to foresee any downside consequences. There were certainly precedents, such as the creation of extreme asset bubbles in Japan. In fact, the Federal Reserve had worried about Japanese-style deflation in the early 2000s, the result of Japan’s own busted real estate and stock bubbles.

On the contrary, the biggest players only saw the upside. Greenspan in fact trumpeted the advantages of exotic (and unregulated) derivatives that spread the risk more widely, that he thought lessened the dangers of default. Yet Greenspan of all people should have foreseen the crash.

I remember well that he encouraged risky mortgages by recommending adjustable rate mortgages as preferable to fixed rates because their interest rates were lower, even though he admitted at hearings he only borrowed at fixed rates! A housing bubble was most unlikely, he said, because home owners couldn’t buy and sell their homes like stocks. Their transaction costs were higher, the housing market was less liquid—and moving costs were considerable.

This was when the Fed had been holding down short-term interest rates in 2003-4 almost as low as today in a bid to fight Japanese-style deflationary fears, and boost a recovery that hadn’t yet added one net job from the end of the 2001 recession. Because inflation was so low then—below 1 percent—the cost of money was in fact less than zero, which made it advantageous to mortgage with little or no down payment.

Why could some of the “smartest guys in the room” so miscall the worst downturn since the Great Depression? Greenspan for one, a disciple of Ayn Rand, believed that free markets embodied the highest moral order (his words). What made it moral? Greenspan, as Ayn Rand, et. al., believed that free market forces were the most efficient and impartial allocator of resources. So when crises did occur, they functioned as a market clearing device, and any attempt to mitigate their effects only prolonged the adjustment to new circumstances. Such crises embodied the forces of ‘creative destruction’ and shouldn’t be tampered with, in other words.

This is why many conservative economists who decried the stimulus spending said “let the banks fail”, so that bad debt can be wiped out. Creative destruction—the replacement of failing businesses with more vibrant ones—happened in nature, so why shouldn’t it be allowed to happen in the urban jungle?

The problem was that Greenspan’s ideology was outdated, and had become group think. The invisible hand of Adam Smith was no longer sufficient to control market forces that had become complex beyond understanding. Bubbles were caused by ignorance of fundamentals, including fundamental market forces that could go easily out of control when greater risk taking was encouraged, with no limits on borrowing.

Household incomes had been steadily shrinking in real (after inflation) terms since the 1970s, except for a short while in the 1990s, so the housing bubble and easy credit encouraged many households to spend borrowed money to keep up their standard of living, a standard that was now beyond their means.

A sustainable economic system in today’s world has to take more than individual self-interest into account, since more than the individual is affected. Financial markets are today intimately linked, so that markets may collapse world-wide if leaders are not held accountable for their risk-taking. Alan Greenspan made a choice of individual gain without regard for its consequences when he chose to ignore the housing bubble. But the captains of industry-and government-have to be held accountable for the welfare of all those affected by their actions as well.

Harlan Green © 2010