James Dainard, a Principal of Intrust Funding, with cohost David recently interviewed Nick Timiraos, reporter and economic correspondent at The Wall Street Journal, about the Fed. Read major excerpts from the transcript, answering the question, “How the fed interest rate hike effects real estate investing,” below. Watch the full episode of “On The Market” Podcast in.
All questions are from James or David, and all answers are by Nick Timiraos.
What is the Federal Reserve and how does it influence the U.S. economy?
The Federal Reserve is a bank for banks. That’s the easiest way to think about it. So they set the price of overnight money. That is their short-term interest rate. So whenever you hear about a Fed meeting and they decided to move up their interest rate, they’re deciding to set the overnight price of money. Either they’re raising interest rates because they want to try to slow down the economy or they’re cutting interest rates because they want to provide more stimulus. And that’s the ballgame for the Fed.
They have two goals assigned to them by Congress, which is to maintain stable prices and to have maximum employment. And you could think of that as the most employment possible without having inflation. And those are their two goals. And then in addition to all of that, they’re charged with regulating the banking sector. Again, think of a bank for banks. They are there to make sure the banks don’t turn themselves into casinos.
By stable pricing do you mean controlling inflation?
Yeah. Having mild inflation for a long time, the Fed didn’t say exactly how they defined that price stability objective. And then about 10 years ago, they formally set a 2% target for inflation. The idea behind 2% was you wouldn’t want it to be zero because you maybe get too close to deflation.
Why is there such a huge swing in the interest now versus the recovery rate of 2011? The Fed was still at zero, but the rates were about a point higher back in 2011 when we were at least locking at rates.
So that’s true. I mean, I think you had interest rates fall into the high twos in 2020 and may have hung out there in 2021. What you’re seeing now though, I mean, if you’ve been in the mortgage market in the last few weeks, you see how things are changing. And so the Fed, one argument is well with inflation at 8%, why is the Fed only raising rates by 25 basis points, by a quarter percentage point? That doesn’t add up. But if you look at their communications since January, where they’ve said, we’re going to raise rates and we’re going to raise rates rapidly, Lael Brainard, the incoming vice chair of the Fed says, “We’re going to raise rates expeditiously and we’re going to shrink the balance sheet rapidly.”
So where are we today?
It’s pretty simple. The Fed thinks inflation is too high. And some people might say, “Well, duh, where were you last year Federal Reserve? Where were JJ Powell last year?” But what happened last year was we were coming out of the pandemic and there was a view that the prices that were rising the most were in these supply constrained categories, airfares, used cars, the rental car fleets have liquidated during the pandemic. And then they had to go replenish last year. And so they bought used cars at auction that sent used car prices up. You have chip shortages. So new car production can’t keep up, prices go even higher.
And so for a while, of course, the Fed infamously said, and a lot of private sector economists agreed, that this was transitory. The idea behind that was that inflation was really driven by the pandemic. And assuming the pandemic was over with quickly, inflation would be too. Where we are today, that hasn’t been what happened you saw, especially in the last part of 2021, the labor market tied in rapidly. And the Fed pays a lot of attention to that because what they really are focused on is underlying inflation. They call it the persistence of inflation. And the most persistent inflation items are labor intensive services.
Think about getting your haircut or going to the bar where the main price of what you’re paying for is labor. So if wages are rising because the labor market’s tight, that is not transitory inflation. And that is inflation that is very hard to reverse once it starts. And then course rents are another big example of persistent inflation. When the economy’s booming, when people have jobs, they’re forming households, they’re willing to pay more for housing. And housing’s obviously, badly supply constraint in a lot of the places where people want to live. So what happened last year was the Fed decides, “We think this is transitory, we’re going to ride this out. We’re going to be patient.”
By the end of the year, Powell, abandons that he says, “We still think prices are going to come down. You don’t think prices of used cars can continue to go up 40% year after year, but the labor market’s probably getting really tight.” And now he says, he thinks the labor market is overheating. He at the last Fed press conference in March said the labor market is tight to an unhealthy level, which my jaw was on the floor when he said that, because this is somebody who all through 2021 was talking about having a really strong labor market recovery and saying that you think the market is now unhealthy to sign that maybe we’ve gone past the point of full employment.
And the Fed doesn’t want to be in a place where they’re having to raise interest rates to create unemployment. The way you create slack in the market is you actually throw people out of work. And that almost always actually strike almost that always has led to a recession. Whenever the unemployment rate rises by a little bit, it goes up by a lot. So where we are now is the Fed is worried. They’re worried that one year of high inflation is okay, but if we have a second year of that, people are going to begin to build expectations of higher prices into their wage setting and price setting behaviors. And that psychology is something the Fed really strongly wants to avoid.
And that was where we were up until February war in Ukraine, energy prices going up, commodity prices going up, supply chain, which you thought was going to get better by maybe the spring not going to get better this spring. And so that’s why you now see a Fed that is very determined as signal, let’s get to a neutral interest rate. A neutral interest rate is the level the Fed thinks isn’t providing any stimulus to the economy. If you think of the economy as a car and the Fed is the driver, they’re taking their foot off the gas. They’re not pushing on the brake, but they’re trying to find that place where they’re no longer pushing on the gas, not necessarily stepping on the brake.
And the big question for interest rates over the next 12 to 18 months is, does the Fed decide we need interest rates above neutral because we need to step on the brake. We need to slow this thing down because it’s just going too fast.
How high will interest rates and inflation go?
I mean, that’s the million $64,000, whatever you want to call it question right now. How high does the Fed have to go? So, let’s step back. What is inflation? Inflation is supply and demand out of balance. That’s what we have here or supply and demand are just out of balance. Last year, the Fed thought it was mostly supply, supply chain bottlenecks, people not wanting to work because they are concerned about COVID or they have a lot of money socked away. So they’ll retire early. Now, it’s clear that, that isn’t the case. It is strong demand. You have a lot of demand. You have more people working, making more money, spending money on things. You have had a shift of spending towards goods away from services and the supply chain couldn’t handle that. So you had extreme price, increases.
To get to your question, now how high will interest rates have to go? The Fed can’t do a lot in the near term about the supply side of the economy. They can’t create more oil, they can’t create more houses, their tools just don’t do that. So when they talk about bringing supply and demand into balance, they either need to get lucky, they need to get supply chains moving again. People who are not in the labor force coming back to work, those are not things they can control. So they are hoping to get help from the supply side of the economy. But if they do not, then they have to throttle back demand. They will have to reduce demand to bring supply into balance.
So how high will interest rates have to go? It really depends on how much help do they get in the next two quarters from the supply side. If they do get that help, if used car prices come down and you begin to see inflation come down, because that was such a big contributor to inflation last year, then maybe they won’t have to raise interest rates very much above again, an estimate of neutral. There’s another question there about what is a neutral interest rate? The Fed, when they submit their projections every quarter, this is called the dot plot. It’s a grid that shows where all of the participants at the Fed meetings think interest rates are going to be at the end of this year or the end of next year, the year after that.
They also project where they think interest rates should be over the long run. And that interest rate has been between two and 3%. So we could take that as the estimate of neutral, but that estimate assumes that inflation is at 2%. So a nominal neutral rate of two to 3%, assuming inflation’s at 2%, if inflation ends up at a higher level, let’s say 3%, then to get that neutral rate, you’re actually talking about a higher interest rate. You have to get interest rates up to three or 4%. And so, this depends on a lot of things that are out of the Fed’s control. How far does inflation come down?
How quickly does inflation come down and do you see expectations of future inflation becoming, the Fed calls us [inaudible 00:31:01] where people expect per prices to be higher. If they get the good story, the positive story, people come back to the labor force, wages come off the boil, the supply chain heals, you don’t see inflation spreading out into the service sector, then they may not have to raise interest rates very much. Maybe they get up to their most recent projection so they’d get interest rates up to just below 3% by the end of next year. And then hang out there for a while. That’s the optimistic scenario.
The other scenario is interest rates go much higher than markets are expecting much higher than we’ve seen since before the 2008 financial crisis. The Fed fund rate in 2006, peaked at five and a quarter percent. So, that’s much higher than anybody has on their radar screen right now. And there’s a risk. The Fed will go there because I’m not saying 5%, but above the 3%, high end estimate of neutral because either they have to chase inflation down or they can’t actually tide in policy because they would want to raise interest rates above the inflation rate to actually slow down demand.
What should they be paying attention to over the next couple months in terms of Fed policy and how can they read into the news that’s coming out to help plan their own investing and financial decisions?
Before this crisis, the big data point that everybody watched to see is the Fed going to raise interest rates at the next meeting was the jobs report. So the first Friday of every month at 8:30, the labor department issues the job support and people would say, “Oh, if hiring’s really strong, the Fed will feel like they can raise interest rates.” If you want to understand over the next few months what’s going to happen, then pay attention to the monthly inflation report. The CPI report, which comes out usually around the 10th day of every month. And the reason that’s important is because the Fed is looking to see whether the month over month pays of inflation slows. They measure this, looking at the 12 month figure the year over year, but pretty soon here, beginning next month, a year ago, inflation began to rise.
So the comparisons are going to get flattered because you’d have to have much higher inflation to have the year over year number go up. So the year over year number probably after this next report, which will be a high one because of the energy increase from the war in Ukraine. The year over year number may not be as important. But look at the month over month number, for the Fed to be hitting a 2% inflation target, or even getting inflation down to 3%, they would want to see something closer to a two tenths to three tenths of a point increase in inflation, or less than that. Less than that would be great if it was 0% for a month that would be very reassuring to the Fed. They would want to see that. If on the other hand, you continue to see where it’s been a five tenths, six tenths of a percentage point month over month increase in inflation, that is not at all consistent with what they want.
That’s consistent with a 6% annual inflation rate or even higher. And so if you really want to understand what’s happening for the Fed for the next few months, I would say, obviously pay attention to what they say. They mean what they say. When the Fed chair and the vice chair in waiting say that they plan to expeditiously raise interest rates, when they say that they want to get interest rates as fast as they can back to a neutral level, that means they’re going to 2%, at least unless something in the economy breaks and something in the financial markets break and then they’d have to decide how they manage that. So listen to that, but also look at the monthly inflation numbers, because I think that’s going to be where the most near term information is going to come on how comfortable or panicked they feel about where the economy is right now.
What do you mean by something in the economy breaks? Is that like a housing bubble pop or is that a stock market…?
Yeah. It would be, if you saw signs of dysfunction in the financial markets, then that would be… I don’t know how they would address that, but that’s what they’re trying to avoid. What they’re trying to do right now is they refer to as tightening financial conditions, which means they want to see the cost of borrowing increase. That means stock prices coming down. It takes some of the froth out of the economy, but they don’t want that to happen in a disorderly manner. So sometimes you think about going up the stairs, going down by the elevator. Well, they like to go down by the stairs here. If you have big discontinuous drops then that would be concerning. And I’m not at all suggesting that would be enough to throw them off their track right now of raising interest rates.
But so long as that doesn’t happen, they will feel like they have a green light to raise interest rates. And remember, many interest rate increases this year. So the market is already pricing in a half point increase at the May meeting. The market is already pricing in a half point increase at the June meeting. As we get closer to those meetings, if the market is saying, we’re expecting this, then that’s an open door and the Fed will take it. They will walk through that door. All of this is happening in a way that isn’t really disrupting economic growth. Yes, you’re seeing the housing market slow and you’ll probably continue to see the housing more slow, but that’s what the Fed wants when they raise interest rates.
They want activity to cool, they want to remove some of that excess demand that you have right now. And so if you’re in situations where homes that used to be getting 10 or 30 offers are now getting three or four, for the Fed, that’s probably a healthy development.