Humphrey Financial, LLC

03/24/2023

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12/06/2022

The Aftermath Economy

We will forever believe that locking down the economy for COVID-19 was a massive mistake. There is virtually no evidence that death rates were lowered by government mandates and lockdowns.

Business activity in certain sectors would surely have slowed as individuals protected themselves from COVID: think hotels, cruises, restaurants & bars, amongst other services. But the government didn’t have to aggravate the problem by applying a version of medical central planning. Doctors, epidemiologists, and scientists can be very good at coming up with treatments, cures, and vaccines, but they’re not equipped to weigh trade-offs that involve costs outside the medical arena, like loss of income or basic freedoms.

There is clear evidence that closing schools caused a harmful loss of learning, which could affect the incomes of future workers for decades, while paying people not to work has warped the labor force.

Economically, the United States ran up about $5 trillion in additional debt and boosted the M2 measure of the money supply by more than 40% during the pandemic, which caused a 40-year high in inflation. In turn, this inflation led politicians to release hundreds of millions of barrels of oil from the strategic petroleum reserve in an attempt to temporarily reduce energy prices.

In other words, the US enters the decades ahead with more debt, less spending power, an undereducated population, and less petroleum put aside for national defense. The US has made the future riskier.

At the same time, no one can know exactly what the near-term future looks like. Right now, the conventional wisdom is that the US faces a recession. Normally, we would disagree with the conventional wisdom, but this time we agree. Unwinding COVID policies will be painful.

Most people think that a recession is coming because the Federal Reserve is lifting interest rates. In mid-November, the US yield curve was inverted with 2-month Treasury bills yielding more than 30-year notes, suggesting that long-term investors think the Fed has gone too far.

Obviously, raising interest rates has hurt the housing market and imagining more economic damage to other sectors as these rate hikes bite seems straightforward. However, this is the first rate-hiking cycle in an inflationary environment under an “abundant reserve” model of managing monetary policy. The Fed has held interest rates artificially low for a very long time, and at least for now, the entire yield curve is still below current inflation rates.

But the real reason we expect a recession is that COVID policies severely distorted the economy. For example, from February 2020 through September 2022, real personal income increased just 2.6%, while real personal consumption climbed by 6.6%. And this happened with fewer people working because of lockdowns and overly generous unemployment benefits. We estimate that Americans have worked about 30 billion fewer hours during the past 2½ years than would have happened if COVID had never hit.

Yet, federal tax receipts hit 19.6% of GDP in 2022, a near record high, in spite of the lockdowns, while corporate profits jumped 23% between the end of 2019 and the second quarter of this year.

The US borrowed from future generations and handed out pandemic benefits that more than replaced lost earnings. Then it taxed the economic activity that this borrowing created, and kept small businesses closed in many states, while large public companies remained open. The result is that spending, profits, and tax receipts were all artificially lifted above normal. The whole economy got distorted and is still untwisting from those distortions.

It’s as if the US economy had a car accident and the emergency responders injected it with morphine. As this morphine continues to wear off – via rate hikes and smaller deficits – it is hard for us to imagine that these above normal trends will continue. In other words, a recession is in the cards.

And with that recession, profits are likely to fall. The combination of lower profits and higher interest rates create a headwind to markets and turbulence for investors.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

09/26/2022

Will Higher Interest Rates Tame Inflation?

We know many people think we are beating a dead horse, but this horse is far from dead. Instead, she’s in the middle of one of the most important races of her life. What we have been talking about – and will keep talking about until we think Americans understand it – is monetary policy and the Federal Reserve.

Ludwig von Mises once said that the value of money is at least as important to a society as its Constitution. The value of money should be sacrosanct, and Government, if that’s who’s in charge of it, has a responsibility to keep it stable. Fourteen years ago the Federal Reserve completely changed the way it manages the value of our money when it shifted monetary policy from a “scarce reserve” model to an “abundant reserve” model, and we believe there is a direct connection between these actions, and the dramatic decline in the value of our money the likes of which we haven’t seen in 40 years. Inflation undermines work, living standards, investments and is a nightmare for future planning. The Fed has failed.

In a scarce reserve model, the Fed can add or subtract reserves from the banking system and through this mechanism push the federal funds rate (FFR) up or down. Banks compete for these reserves and, through a market of bids and asks, set an interest rate for reserves. In an abundant reserve model, there are so many excess reserves that banks don’t need to compete for them. The FFR is essentially zero because only in very special situations do banks need to borrow reserves. So the Fed created an interest rate that it pays on excess reserves (the IOER), which acts as a floor for interest rates, and that rate is whatever the Fed decides it is.

In other words, while under the old system the market was involved in setting interest rates, today, the Fed now artificially sets interest rates. And as you might deduce, if the government sets interest rates, they likely set them lower than they would be if markets decided what interest rate was correct.

The Fed declares success when market rates move with its rates. But this is a test with a determined outcome. If the Fed grew five trillion bushels of corn, and corn was so plentiful that the price per bushel was essentially zero, then no private farm could sell corn for more. If the Fed then raised the price of its corn to $1/bushel, farmers could then sell theirs for 99 cents/bushel, but it’d be a completely manipulated market.

So, while raising interest rates may reduce economic growth and may throw the US into recession, there is no guarantee that this will fix inflation. Interest rates don’t determine inflation; the amount of money circulating in the economy determines inflation. And this is where the problem lies.

The Fed’s balance sheet held $850 billion in reserves at the end of 2007. Today, it is close to $9 trillion. Most of these deposits at the Fed are bank reserves which the Fed created by buying Treasury bonds, much of which was money the Treasury itself handed out during the pandemic. At this point, if we add excess reserves to reverse repos, there are over $5 trillion in excess money in the system.

Technically, banks can do whatever they want with these reserves as long as they meet the capital and liquidity ratio requirements set by regulators. They can hold them at the Fed and get the interest rate the Fed sets, or they can lend them out at current market interest rates. In turn, the big question is whether the Fed can pay banks enough to stop them from lending in the private marketplace and multiplying the money supply.

But we’ve never done this before. We’ve never tried to stop bank lending in an inflationary environment by just raising the IOER. What interest rate is enough? And when will politicians go bonkers over how much the Fed is paying the banks? After all, if we combine how much the Fed pays private (foreign and domestic) entities on both excess reserves and reverse repos, at a 3% rate it will be $150 billion per year.

If the Fed raises rates to 4% under this new method of managing monetary policy, it will pay private entities $200 billion per year! Wait until politicians who love to hate banks find this out! Moreover, the Fed is now losing money on much of its bond portfolio because it bought so many bonds at low interest rates. At some point the Fed will be paying out more in interest than it is earning on its securities.

Jerome Powell was recently asked if he would ever go back to a scarce reserve model. He said no way. He argued that because of recent crises (2008 financial crisis and the Pandemic) this new abundant reserve model is better. To be brief, government always uses crisis to grow and we would have never had the inflation we have today under the old model.

Like the rest of the government, the Fed has become way too big. Too many resources, and too much power in the hands of so few is antithetical to free markets. To say we are worried about this is an understatement. We just wish more people understood it and called the Fed to task. The Fed should return to a scarce reserve model as soon as possible. We feel like Don Quixote, but we won’t stop dreaming.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

09/14/2022

Home Prices Plateauing, Rents Catching Up. September 6, 2022

The housing sector surged during COVID in large part due to loose money. The Federal Reserve kept short-term rates artificially low and the M2 measure of the money supply soared. Now, with rising short-term rates and slower growth in M2 sending mortgage rates higher, the housing sector has a bad case of indigestion. Sales are down, construction is down, and the most recent reports on home prices show a sudden and sharp deceleration.

This should sound familiar, because it’s very similar to what happened to “real” (inflation-adjusted) retail sales. Sales soared in 2021 but have since plateaued, as growth in consumer spending has come from services, not goods. Expect something similar in the next few years with housing, with national average home prices roughly unchanged while rents continue to catch up.

Recent problems in the housing sector are widespread. Existing home sales have dropped for six straight months and, with the exception of the first few months of COVID, are the slowest since 2015. New home sales are the slowest since early 2016, even if you include those horrible first few months of COVID.

Private residential construction rose for twenty-four straight months through May and has now declined for two straight months. Meanwhile, after peaking at a 1.805 million annual rate in April, housing starts fell almost 20% to a 1.446 million rate in July. In time, fewer housing starts today will lead to less overall construction and home completions later this year.

But perhaps the most dramatic change is on prices. The national Case-Shiller index rose more than 1.0% in every month from August 2020 through May 2022. Every single month. Home prices rose a total of 8.9% in the first five months of 2022. More of the same. But then came June, when prices rose a meager 0.3%.

As a result, some are thinking we are in for a massive housing bust the kind of which hit the US after the last boom in the 2000s. But we think that’s highly unlikely. Housing is going to feel some pain, but we are facing nothing like what happened in the last housing bust.

Last time, national average home prices bottomed in 2012 about 25% below where they peaked in 2007. From peak to bottom, housing starts plummeted 79.0% and new home sales fell 80.6%. These are not typos! Existing home sales dropped 52.3%. Mix all these changes with mark-to-market accounting and no wonder we had a Financial Crisis and the Great Recession. That’s not happening this time around.

So why do we think we are not in for a huge housing disaster like last time? First, because the last housing bust was preceded by several years of massive overbuilding. We simply had too many homes; too many homes available for sale, as well as too many homes available to rent. By contrast, the most recent turbulence in the housing market has not been preceded by overbuilding. If anything, we’ve built too few homes in the past decade, not too many.

Second, although home prices have risen substantially since 2020, relative to replacement cost, they are only up about 2% and only about 4% higher than the median in the past forty years. No big deal. Why does replacement cost matter? Because the more it costs to replace your home, the more your current home is worth. So, yes, home prices are up substantially, but if the costs of copper pipe, drywall, lumber, and labor are up, too, then it makes some sense for home prices to be up, as well.

Third, rents should continue to rise at a rapid pace, putting a sturdier floor under home values. In the last housing crisis, not only did home prices fall but housing rents decelerated sharply and then temporarily went negative, as well. Think about that: many people were leaving home-ownership but landlords couldn’t squeeze them for more rent because there were simply too many homes.

Now, in the current environment, where higher mortgage rates are persuading some potential home buyers to remain renters, landlords are in a much stronger position. They can keep raising rents because the market isn’t oversupplied with homes. And, in turn, higher rents should keep home prices from falling like in the prior housing bust. The more a home can generate in rent, the more valuable the home.

The bottom line is that what we are seeing right now in the housing market is a bad case of indigestion from higher interest rates. Due to overly loose monetary policy and other COVID-related policies, home prices got too high versus rents in the past couple of years and both prices and rents need to correct. We project continued gains in rents in the next few years as home prices are roughly unchanged. The maximum drop in home prices from the peak to the bottom in this cycle should be around 5%, not a 25% implosion like last time.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

09/05/2022

Biden’s Student-Loan Fiasco. August 29 2022.

The Dow Jones Industrial Average fell more than 1,000 points on Friday, caused apparently by Fed Chairman Jerome Powell’s attempt to use a brief speech to channel the ghost of Paul Volcker. Obviously, this was part of the market’s worries, but the stage was set when the Biden Administration announced a student loan forgiveness program last week. The more we learn about this, the worse it looks.

The executive order would send an already very bad student loan system – a system designed more to create jobs for academics than to really help students – into overdrive, generating huge costs for taxpayers, soaring college prices, and a massive shift in resources toward the already bloated college sector, which already generates negative marginal value-added for both students and our country.

The Biden Administration says the changes would cost $240 billion in the next ten years. The Committee for a Responsible Federal Budget says $440 - 600 billion. A budget model from Wharton says $1 trillion. But even that $1 trillion figure might be way too low.

The key is that, as bad as it is, the cancellation of some student debt that already exists is only a small part of the policy change. The much bigger change, and the one that the market has finally begun to absorb, is limiting future payments on debts to 5% of income, but only after the borrower’s income rises above roughly $30,000 per year. For example, if someone makes $70,000 per year, then no matter how much they borrow they’re limited to paying $2,000 per year (5% of the extra $40,000). After twenty years, any remaining debt would simply disappear.

Think about the perverse incentives!

For the vast majority of students, choosing this “income-based repayment” system would be a no-brainer. And once they pick it, they wouldn’t care at all whether their college charges $35,000 per year (tuition, room, board, and fees), $85,000, or even $150,000. In fact, students would have an incentive to pick the priciest college with the best amenities they could find and pay for it all with federal loan money, because their repayments are capped. If you always wanted Rodney Dangerfield’s dorm room from the movie Back to School, you’re in luck!

Meanwhile, students would have the incentive to take out loans greater than what they need because they can turn the excess into cash for “living expenses.” Then they could use it to buy crypto, throw parties, or pretty much anything else. Who cares?!? The government would limit their future repayments.

And here’s what might be the worst part: colleges would have an incentive to enroll students even if they have horrible future job and earning prospects. By enrolling people no matter how poorly prepared they are, a college can charge whatever they want and get huge checks from the federal government. And the unprepared students won’t care because they really don’t have to pay it back. In effect, colleges could create massive and perfectly legal money-laundering schemes.

We are not legal experts and do not know whether the new proposal will be implemented fully. But, if it is, watch out: college costs are poised to skyrocket and academia is courting a political backlash of enormous proportions. Meanwhile, the market is attempting to digest just how far from economic reality politicians have become. The political allocation of capital is a recipe for economic disaster.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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