This week’s chart, depicting U.S. 10-year Treasury rates over the past 15 years, is a picture of central bank intervention — including a sharp reversal in 2022. For years, the main risk that worried central banks has been deflation. Generally speaking, everyone feels that inflation is a problem we know how to solve: by raising interest rates and tightening monetary policy.
Monetary policy works its way into the economy through wealth effect and income effect, eventually leading to changes in consumption and gross domestic product (GDP) growth.
Tighter monetary policy tends to lead to lower valuations for financial assets and the housing market. The negative wealth effect is an important way that monetary policy influences the economy. During 2022, $36 trillion of value has been lost in global stocks and bonds, outpacing the $23 trillion loss in 2008 and $25 trillion loss in 2020.1
So far, we haven’t seen a material consumer slowdown yet. The latest real personal spending data showed 0.1% month-over-month growth in August, and there hasn’t been much of a slowdown over the last several months. 2 The reason that we are not seeing a sharp slowdown in consumer spending is likely because the labor market is still strong. Historically, the impact of the wealth effect on the economy has been muted. Before 2020, it was one of the main tools that the Federal Reserve (Fed) utilized to raise the inflation rate in the economy, and it hasn’t been successful.
The income effect of higher interest rates primarily comes from higher debt service costs for households and corporations. The interest burden is currently close to the lowest level for both households and corporations over the last 50 years.3 The vast majority of debt and mortgages are fixed rate, and corporations have extended their debt maturities. Yes, the higher financing costs will make large purchases more expensive, as we’ve seen in housing and will likely see in auto. However, I am not sure if this alone can slow down the economy enough to bring down inflation.
The economy’s low sensitivity to interest rates is a significant challenge to the Fed’s battle against inflation. Low sensitivity means the money supply will have to become very tight for inflation to come down.
The September Consumer Price Index (CPI) report tells this story. Core CPI month-over-month was 0.58%, a new high for this cycle. Goods inflation is almost flat month-over-month, reflecting the lower commodity prices and easing of supply chains. However, the core service inflation rate came in very strong at 0.8% month-over-month, despite a series of large rate hikes and an equity bear market. In my opinion, this should concern the Fed. Yes, it is widely recognized that the effects of monetary policy come with a lag, but I wonder how long that lag is now in an economy where finance plays a very significant role. 4
Looking forward, housing-related inflation will come down, as more alternative data sets are showing a weakening in rental and housing prices. Medical care services prices will also decrease as medical costs annually reset lower in October. These developments will lead to lower CPI in the next few months, but the level where inflation will eventually end is still highly uncertain.
Recent bank earnings tell a similar story. Bank of America mentioned that consumer spending is still growing, and the delinquency rate is very low. Upgrades are exceeding downgrades on the commercial lending side. The stronger the consumers and corporations, the more the Fed has to do to break the momentum of the economy.5
The balance sheets of consumers and corporations are in good shape. Meanwhile, the economy’s sensitivity to monetary policy may not be as high as before, especially considering the strong job market. This makes the Fed’s fight to contain inflation more challenging. The risk to the market is that interest rates need to go even higher. Put spreads for Treasury bonds could be a cheap way to position for this possibility.
1Source: Bloomberg- Raging Markets Selloff in Five Charts: $36 Trillion and Counting; 10/1/22
2Source: Trading Economics- United States Personal spending; as of 10/19/22
3Source: Goldman Sachs- 4 Charts - Can US Households handle the pace of Fed hikes? ; 10/11/22
4Source: FRED Economic Data- Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average; as of 10/19/22
5Source: CNBC- Bank of America CEO says latest spending and savings data show that the U.S. consumer is healthy; 10/17/22
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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