The Fed Is Making Inflation Worse
The Federal Reserve is its own worst enemy…
Since our central bank first started raising interest rates in March 2022, it has had a clear goal… to bring down the pace of inflation growth. Because, if the rate of household pay growth can’t keep up with the average annual costs increase, then individuals will start falling into a financial hole.
We can see this by comparing the rates of personal income and core personal consumption expenditures (“PCE”) growth…
In the above chart, I’ve subtracted the rate of inflation growth from the rate at which household income has increased. We can see that over the last decade, income has outpaced inflation by an almost 3% average.
We can see that income exploded higher in 2020 and 2021 as the government handed out pandemic-driven stimulus. At the peak in March 2021, it outpaced price growth by almost 30%. But, as you’ll notice in early 2022, due to all the consequent demand, inflation took off as income growth slowed, with the difference troughing at -18%. That was in March, the same month the Fed started raising interest rates.
Ever since, as rates have gone up, the gap between personal income and inflation growth has started expanding once more. April’s 1.7% increase is one of the highest level we’ve seen since before the pandemic and closing in on the 10-year average.
But the catalyst for the next leg up may come down to the Fed. You see, with interest rates staying high, it’s driving up the costs for all types of loans. That means households and businesses must pay more any time they need to borrow. So, a rate reduction of as little as 25 basis points, could help ease cost burdens everywhere. The change would support economic growth and a steady rally in the S&P 500 Index.
But don’t take my word for it, let’s look at what the data’s telling us…
To see what I’m talking about, there are two main types of payments we can look at that affect most households. Those are mortgage and credit card payments. Because, according to the National Association of Realtors, 85 million out of the 129 million U.S. households are owned versus rented. That means, roughly 212 million people are affected by monthly mortgage payments. And, according to the St. Louis Fed, 51% of those entities have credit card debt.
So, let’s start with mortgage payments…
In 2019, just before our central bank began to introduce easy money monetary policy, the rate on a 30-year conventional mortgage averaged 3.9%. For someone looking to buy at $400,000 home with 20% down, that would mean a monthly mortgage payment of $1,846, according to consumer finance website bankrate.com. The breakdown would be $320,000 in loan amount (light blue line) and $226,00 in interest (green), resulting in a total cost of $546,000 over the life of the loan (the dark blue line represents the loan balance).
By 2021, just before our central bank began raising rates, the rate on a 30-year conventional mortgage dropped to just under 3%. That same $400,000 home with 20% down, would have a monthly mortgage payment of $1,671. The breakdown would be $320,000 in loan amount (light blue line) and $163,200 in interest (green), resulting in a total cost of $483,200 over the life of the loan.
The change is a savings of roughly 11.5%. That’s a lot of spare change to spend on other items like gaming consoles or televisions. But now, let’s fast forward to today…
Last year, following a series of rapid rate hikes by the federal reserve, the rate on a 30-year conventional mortgage shot up to an average 6.8%. The $400,000 home with 20% down, would now have a monthly mortgage payment of $2,417. The breakdown would still be $320,000 in loan amount (light blue line), but the interest (green) total has jumped to $431,800, resulting in a total cost of $751,800 over the life of the loan.
In other words, due to the series of rate hikes, the total interest cost of a mortgage has jumped by 265% between 2021 and today. If we look at those numbers in pre-pandemic terms, the total has jumped by 190%. Either way we look at it, those numbers far outstrip the pace of headline inflation growth, all because the rate of interest rate payments has exploded higher.
Now let’s look at credit cards…
According to the St. Louis Fed, the average American household is carrying roughly $8,000 in credit card debt. The group also said the bulk of it is being held by middle income families. But remember, like we said at the top, only 51% of all households carry this type of debt. So, the implication is that those who haven’t paid off their debt load are likely carrying balances double the average number.
That means households stuck paying interest on credit card bills are likely paying a higher sum. Back in 2019, the average rate of interest was 15%. So, at that rate, if you paid down your bill at $200 per month, without spending anymore money, it would take you four years and eight months to wipe out the debt. Over that period, you would pay off the $8,000 in principal, plus another $3,160 in interest, for a grand total of $11,160.
But last year was a different story…
Because of all the rate hikes, the average interest rate on a credit card was 22.8%. According to the Consumer Financial Protection Bureau, that was the highest rate since the Fed records began in 1994. At that rate, if you sought to pay off your bill at $200 per month, it would take six years and four months. You would return the $8,000 in principal borrowed, plus another $7,165 in interest, for a grand total of $15,165.
In other words, the interest cost has more than doubled over the last four years. Like the interest on a home loan, that pace of growth is far worse than headline inflation over that same time frame.
And this is why it’s a problem…
If consumers are feeling this kind of pain on basic borrowing costs, businesses are too. Those entities are seeing interest charges jump just as much if they need to carry debt or invest in expanding their facilities. So, naturally, they’re going to pass those costs onto customers.
That’s going to drive prices higher, until the cycle stops.
In addition, one of the biggest components of CPI is owner’s equivalent rent (“OER”). It’s also a part of PCE but nowhere near as big. OER’s based on a survey asking homeowners how much they’d pay to rent instead of owning their home. When they see what’s happening with mortgage payments due to rising rates, of course homeowners will think their house can rent for more.
That’s also going to boost inflation until the cycle stops.
So, the Fed is part of the problem. Because it won’t cut rates, it’s making inflation worse not better. And, if it waits too long, it could wind up doing unnecessary economic damage by destroying consumer and business confidence.
This past Wednesday, Chairman Jerome Powell said that a 25-basis point rate cut won’t matter 5 to 10 years down the road. Well, those individuals seeking to buy a home or business looking to reinvest may feel very differently. The sooner the central bank listens to its own comments, the better off we’ll all be. Because such a change would underpin economic growth and a steady rally in the S&P 500.
Five Stories Moving the Market:
The Bank of Japan left monetary policy unchanged and said it would reduce bond purchases but delayed providing details until its next policy meeting; investors had been primed for more news on bond purchases, expecting the Bank of Japan to disclose the amount of cuts for its regular operations – Bloomberg. (Why you should care – the lack of detail will likely keep downward pressure on the Japanese yen)
Visa's and Mastercard's proposed $30 billion antitrust settlement to limit credit and debit card fees for merchants is in peril, after a New York judge signaled she was preparing to reject the accord; U.S. District Judge Margo Brodie in Brooklyn told lawyers for the card networks and objectors at a hearing on Thursday that she will "likely not approve the settlement," according to court records – Reuters. (Why you should care – the decision could drive up litigation costs and hurt the forward growth multiple for both companies)
Bank of Canada Deputy Governor Sharon Kozicki said quantitative easing during the COVID-19 pandemic lifted economic output by as much as 3%; she said bank research indicates longer-term yields would have been nearly a percentage point higher had the central bank not intervened – WSJ. (Why you should care – Kozicki said its reasonable to anticipate more rate cuts as inflation keeps slowing)
U.S. Treasury Secretary Janet Yellen said the U.S. employment picture increasingly resembles the job market that existed prior to the COVID-19 pandemic, and slowing wage growth is not a threat to add to inflation – Reuters. (Why you should care – slowing job growth is an outcome the Federal Reserve is seeking)
European Central Bank Vice President Luis de Guindos said it can’t pre-commit to any decisions this year as it confronts volatile inflation and an economy whose outlook is difficult to predict; he stated policymakers don’t have any predetermined path for borrowing costs over the next six months – Bloomberg. (Why you should care – the commentary could support a rally in the euro)
Economic Calendar:
Bank of Japan Policy Announcement
Japan – Industrial Production for April
Eurozone – Trade Balance for April (5 a.m.)
University Of Michigan Consumer Sentiment Survey for June (10 a.m.)
Baker Hughes Rig Count (1 p.m.)
ECB’s Lagarde Speaks (1:30 p.m.)
Fed’s Goolsbee Speaks (2 p.m.)
CFTC’s Commitment of Traders Report (3:30 p.m.)
Fed Releases Balance Sheet Updates on Commercial Banks (4:15 p.m.)