“The standard of living for the average American must go down,” he said. “I don’t think you can escape that.” These were the words of Federal Reserve Chairman Paul Volcker when he testified before Congress in October 1979. Inflation was 13%. Volcker’s predecessors, Arthur Burns and William Miller, failed to control prices. Stagflation gripped the United States. We were in a state of economic death.
Volcker would go on to raise the Fed Funds Rate to 20% in 1981, forcing the country into a deep recession. The 30-year fixed rate hit 18% in October of the same year and unemployment topped 10% soon after. The standard of living for the average American had truly declined.
But in 1986, inflation was defeated (1.9%), mortgage rates dropped to 10%, and the Beastie Boys released “License to Sick.” At the time, I cared about one of these things. In 1988, unemployment was at 5, and I was graduating from high school. The worst economic period in modern US history was ending. Volcker’s tough call worked.
History is full of tough calls.
In WW2, the Brits hacked Hitler’s Enigma machine and learned about the planned Luftwaffe bombing of Coventry, England. Churchill allowed the city’s demise to keep his secret up. Enigma codebreaking was a key factor in the Allied victory over Germany in WW2.
Jacinda Ardern was Prime Minister of New Zealand when the pandemic began. He immediately locked down the entire country in March 2020, issuing a “Stay at Home to Save Lives” order. The economic and social backlash was intense. Throughout the pandemic, New Zealand’s death rate from Covid was 0.086%, the lowest in the world. The death rate in the United States was four times higher.
With a climactic event (pandemic), significant policy misalignment (transient inflation), and deficit spending, today’s Federal Reserve finds itself in a “hard call” position.
The Fed recently lowered the Fed Funds rate for the third time in this cycle while at the same time announcing that inflation will not reach the 2% target until 2027. The Dow Jones fell 1,100 points on the day and the 10-year yield rose by the widest margin. on any Fed day since 2013.
But first, some economic data
I contend that reporting from the Bureau of Labor Statistics (BLS) masks a very weak set of current economic conditions. Exhibit A: QCEW report for November. While the monthly Nonfarm Payroll (NFP) number gets all the headlines about job creation, the QCEW is the “behind the scenes” gold standard. The Quarterly Census of Jobs and Earnings captures 95% of jobs in a sample of 12.2 million establishments. The NFP is a survey of only 629,000 institutions with a response rate of 43%. The NFP has shown a remarkably resilient labor market over the past two years. The chart below shows mortgage-backed securities covered by monthly non-farm payroll numbers for 2024. Note how MBS works when NFP job creation is reported as strong. Of all the economic reports that affect home prices, this one is the big kahuna.
In November of this year, the more robust and accurate QCEW successfully researched non-farm job creation from Q2 2023 to the same period in 2024. When the BLS compiles these figures in early 2025 and they become official, prepare for ~1 million full-time job losses. Remember this past August when the BLS projected 818,000 jobs from Q1 2023 to the same period in ’24? That was not the end.
Chart courtesy of Mishtalk.com.
Exhibit B: Meanwhile, the BLS reports shelter inflation using lagged metrics and independent surveys that inflate the overall rate of inflation. Shelter/Housing is one major component of CPI. A bad quarterback on a good team can make a season run. Housing can impact the CPI differently than others in the commodity basket.
Substitute a more data-driven approach to rent inflation, such as the Apartment List National Rent Index, and you’ll find inflation is already below 2%. Charts by Arkomina research.
So, if the economic data is so wrong or so badly misapplied, is a Fed rate cut inappropriate? If conditions are actually weaker than we think, shouldn’t the Fed have lower limits?
No. Allow me to explain.
Wrong thinking
Jerome Powell and his team are trying to win a tournament they can’t win. They accepted the “soft landing” narrative but forgot how to actually drive. They work like politicians, playing to lose instead of doing the right thing to win.
Here is their problem:
Option A:
• Keep FFR high.
• Ensure that inflation is defeated.
• Tolerating the wrath of the President-Elect and the nation.
• High risk of unemployment and unnecessary recession.
Option B:
• Reduce FFR, announce progress in deflation.
• Avoid hawkish messages to avoid market euphoria.
• An attempt to restore the economy to its pre-pandemic state.
• The risk that dominates the currency and restarts the painful cycle of rate hikes.
The Fed chose option B. It is wrong.
To be clear, I am not Nostradamus. I’m a guy who invested his life’s money in Webvan when he was twenty-seven. But I understand the bond market, and I only need to look at its reaction to see the forest.
What the bond market tells us
Below is a chart of the cumulative change in 10-year Treasuries since the start of every Fed rate-cutting cycle since 1989, courtesy of Bianco Research. 10 year trail as of September 18thth it is also historic to completely reject the actions of the Fed. In other words, the market is not buying what Jay and the team are selling.
The second chart represents 2 and 5 year TIPS. Treasury Inflation-Protected Securities are designed to return the bond’s principal and interest but are adjusted to the CPI. This helps reduce the risk of inflation reducing investment, which is a common concern with bonds. The hash line is September 18ththe day the Fed started cutting the FFR. Market expectations for 2 and 5 year inflation have done nothing but rise since Jay and Team started cutting. The market believes that Jerome Powell risks becoming Arthur Burns. If they’re right, it may take some Volcker-esque pain to right this wrong.
Is the bond market always fair in relation to inflation? No. Is it right this time? It is possible.
Does it matter if the bond market is good or bad now? No.
We have shown that it is much easier for the Fed to stimulate our economy than to slow it down. Assuming the odds of throwing an economic bullseye are slim, which side of the board should we err on the side of?
The bond market’s rejection of the Fed’s current option leads to two of my favorite topics. Risk & Statistics
The risk of option A is recession and rising unemployment. For every 1% increase in unemployment, another 1.7 million people will lose their jobs. Losing a job is brutal, and it’s not my intention to make something hurtful into the equation. If you are one of the affected, your unemployment rate is 100%. But these are tough calls one must accept if one aspires to become Fed Chairman. The downside of option A is another 1.7, or 3.4 or 5.1 million Americans will lose their jobs. At 5.1 million, the unemployment rate would be north of 7%. But inflation will be overcome.
The risk of option B is that inflation dominates. This is why the bond market has started to price and why long-term yields are rising. Inflation affects us all. We have 130 million homes, which are stuck
337 million Americans. A 2023 survey by Payroll.org estimates that 78% of Americans live paycheck to paycheck. A comparable study by Forbes Advisor revealed the same figure at 70%. The same number of respondents have less than $2,000 in savings. Double inflation in this group,
representing more than 90 million households means heavy credit card use, crippling debt, mortgage defaults, student loan defaults, car repos, bankruptcy, and the decision between grocery or rent.
The danger of option A is sacrificing Coventry to win the war.
The risk of choice B is the whole of England.
This may be a tough call, but it isn’t. I mean. Shut up.
The conclusion
The Fed must choose the lesser of two evils. The Fed needs to listen to the bond market and stop playing politician. Abandon the flight plan of “slow down” and remember that there are passengers in the back who are counting on their understanding. It is not their heritage.
Leaders make tough calls.
Back to Paul Volcker in 1979, sitting in front of Congress, concluding his testimony: “We are facing a difficult economic situation, and none of our choices are safe or painless. The time has come to face them.”
Mark Milam is the president and founder of Highland Mortgage.
This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.
To contact the editor responsible for this piece: [email protected].
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