Macro Roundup

"... It is not just that volatility is driving illiquidity. Illiquidity is beginning to cause volatility. If both effects operate simultaneously, they form a vicious spiral in which volatility surges and liquidity collapses. The terrifying thing about a run is that it operates by itself. If you hold treasuries for liquidity and a surge of panic-selling causes the market to seize up, then on precautionary grounds, you must try to sell too so as not to miss your chance. Given the scale of foreign involvement, shocks emanating from anywhere worldwide will reverberate in the market. Foreign sales were an important part of the shock in 2020 when significant emerging market reserve sales occurred. In 2022, given the savage devaluation of the yen and the prospect of a major course correction by the Bank of Japan, the main worry is sales by Japanese investors...."

The housing market may be the biggest single macroeconomic force. US residential real estate alone is worth $53 trillion. But it is illiquid. US equities are valued at $46 trillion. They can be easily bought and sold, but no two equities are alike. You have to pick and choose. The $23 trillion market for US government debt offers a relatively smooth spectrum of homogenous assets that differ only in terms of their duration, ranging from a few weeks to 30 years. They trade on a curve defined in terms of maturity. They are safe assets with no serious default risk offering an extremely liquid market, which provides the ideal platform for financial engineering supercharged with algorithmic high frequency trading. As the largest pool of fixed-income, safe assets, the Treasury market registers vibrations from every piece of economic and policy news in a matter of millisecond. Every day hundreds of billions of Treasuries change hands in hundreds of thousands of trades.

The prices and yields that result from these trades set the benchmark for all other borrowing and lending. The question that haunts the markets right now is what happens when the entire structure of interest rates lurches violently upwards in response to a sudden surge in inflation and the promise of severe central bank action?

The risk is not that Treasuries suddenly become worthless, as a result of US government default or hyperinflation. Nor is there much prospect of a geopolitically motivated bear raid on the US by its foreign enemies. The risk is more mundane, the risk is that the market, driven by greed and fear, will stop working, that prices and yields will become anomalous and upset trillions of dollars in portfolio allocations unleashing a landslide, as hedge funds, banks and other investors scramble for cash.

So large a shock would this be that there is little prospect that it would be allowed to play out to its full catastrophic extent. We dont live in the 1930s anymore. There is an answer to such a crisis - the central bank. But if the Fed were forced to step in, it would imply a shuddering reversal of policy. The shock would move from the markets to the institutions. Credibility would be in tatters. It would amount to a severe intra-elite crisis. Something like the UK suffering but at the heart of the world’s financial hegemony.

You might counter that in 2020 the Fed dealt with a crisis in the US Treasury market and emerged with its reputation for competent crisis-management enhanced. But that malfunction was triggered by a pandemic, a shock that, as far as the financial system was concerned, was exogenous. If something similar were to occur in 2022/23 there would be no excuse. Of course, the inflationary surge that began in 2021 is itself attributable, whether demand- or supply-induced, to COVID. But today what is causing the stress in financial markets is not inflation as such but the policy response of the central banks. They are raising rates as the macroeconomic situation demands. If they cannot do so without triggering a malfunction in the world’s most important financial market, then, “Houston”, we have a problem.

***

For many readers of this newsletter, the 2008 banking crisis will be the benchmark of financial terror. But in 2008 the American government balance sheets was the platform from which the rescue of the banks was mounted. The Treasury market remained solid. Indeed, investors ran to safety in Treasuries. Only in weaker members of Eurozone - Ireland was the prototype - did we see a full doom-loop develop in which a banking crisis overloaded the public balance sheet, precipitating a public debt crisis, which in turn destabilized the private financial system.

The US Treasury market is not immune to shocks. It wobbled badly in September 2019 in the so-called repo market crash. But the real scare came in March 2020 when the Treasury market stopped working for several weeks. This precipitated a panic even more acute than in 2008 and a truly gigantic intervention by the Fed. On several days in late March 2020 the Fed bought more bonds than Ben Bernanke’s Fed’s bought in an entire month at the highpoint of the first round of Quantitative Easing. This story is at the heart of Shutdown, my book about 2020.

It is important to emphasize, in light of the comparison with the Eurozone, that what caused the panic in March 2020 was not concern about the solvency of the US government. The volume of Treasuries has continuously increased because of the deficits run over the last quarter century. And ahead of 2020 the balance sheets of the main actors in the Treasury market were stuffed full by the large deficits run by the Trump administration. In relation to GDP, US government debt was rising and it surged at a wartime rate due to the COVID stimulus. But that was not what the panic of March 2020 was about. Nor is the deficit and new public debt issuance the main worry in 2022. What matters is what private financial actors - banks, investment funds, hedge funds - do with Treasuries and their constant need to churn them through a liquid market. What concerns us is not a crisis of public finances, but a crisis triggered by the private use of public debt.

For all that public debt is a liability of the taxpayer, it is also an asset. You buy assets to benefit from appreciation and their yield. You can use them as collateral for further borrowing. Crucially, you need to be able to sell them in an emergency. That is what US Treasuries normally offer you. But in March 2020 the market stopped working. There were too many sellers and not enough buyers, so the price of highly rated entirely safe securities suddenly plunged and yields surged. To avoid disaster the Fed stepped in as the buyer of last resort. It also offered repo facilities, i.e. loans against Treasury collateral, in the hope that if they could be used to raise funds by way of the Fed, private investors would have less reason to sell their holdings. The combined effect was to flush trillions of dollars of liquidity into the system and to stop the run.

In 2020 inflation was not a concern. Prices were falling. Today, with prices rising the Fed is trying to reverse course. It is trying to tighten monetary conditions. It is raising interest rates and rather than buying Treasuries to provide liquidity, it is selling them, draining reserves out of the financial system. Between September and November the Fed planned a $95 billion tightening. The question is whether the Treasury markets can take it. Without the Fed as the buyer of last resort, will private investors still be able to buy and sell Treasuries smoothly or will the market again become dysfunctional?

***

The signs of stress are clearly there. Both anecdotal evidence and some quantitative indicators suggest a worsening liquidity situation.

The market depth for US Treasuries varies by duration. It collapsed entirely in March 2020, but though it has recovered, it remains well below 2019 levels.

Bid-to-ask ratios that measure how difficult it is to sell Treasuries are at uncomfortably high levels. And, at the primary Treasury auctions, when fresh Treasuries are sold, there is a noticeable weakness of new demand.

Clearly, market conditions are not easy. But the difficulty is to decide how serious these signs are. There are technical reasons discussed in the Fed’s latest Financial Stability Report why some of the commonly cited indicators may exaggerate the liquidity squeeze. Furthermore, as market participants point out, it is not surprising that liquidity should be somewhat tight right now. As we move from one level of interest rates to another, you would expect more volatility and with more volatility you should expect less liquidity. This is a normal market adjustment.

The worry expressed by several market participants to the FT is that causality is also beginning to run the other way around. It is not just that volatility is driving illiquidity. Illiquidity is beginning to cause volatility. If both effects operate at the same time they form a vicious spiral in which volatility surges and liquidity collapses. Given this possibility the question of what is the precipitating factor may become moot. The terrifying thing about a run is that it operates by itself. If you hold treasuries for liquidity and a surge of panic-selling causes the market to seize up, then on precautionary grounds you must try to sell too, so as not to miss your chance. Whatever your underlying long-term motivation, you must join the crowd.

As a recent paper from the New York Fed by Thomas Eisenbach and Gregory Phelan shows, this kind of run dynamic with “precautionary selling” appears to have built up in Treasury markets in 2020. It would be disastrous if it were to recur.

***

At this point you might wonder why this vital market is so opaque. If this is the most important financial market, if this is the sovereign debt of the most powerful state, why is there so much uncertainty and volatility?

Part of the problem is that the range of investors holding treasuries is huge. The largest single group of Treasury investors are reserve managers from across the entire world.

Given the scale of foreign involvement, shocks emanating from anywhere in the world will reverberate in the market. Foreign sales were an important part of the shock in 2020, when there were significant emerging market reserve sales. In 2022, given the savage devaluation of the yen and the prospect of a major course correction by the Bank of Japan, the main worry are sales by Japanese investors. We will return to that in a future installment of this series.

But pointing finger at foreign investors can be a way of diverting from the main problem. Japanese pension funds and banks are just one part of the giant transnational system of shadow banking for which US Treasury bonds are the rocket fuel. The main hub of this system is not in Tokyo but in New York.

The emergence of this system from the 1950s onwards is beautifully chronicled by Tracy Alloway in an extraordinary essay for Bloomberg which draws heavily on the work of the brilliant Josh Younger. As Younger put it: “In the early 1950s, the Federal Reserve and Treasury leaned heavily on dealers to jump start a ‘free’ Treasury market — one where prices were set by investors not the government,” explains Younger. “In many ways, we’re still living with the legacy of those policy decisions. The Treasury market today is arguably only as healthy as the shadow banking system on which those dealers depend.”

The system that has emerged is fragmented and unstable. The Financial Stability Board provides the following map for the secondary market, with further complexity added by repo and futures markets.

As Vanderbilt Law Professor Yesha Yadav points out, it is not just the markets themselves, but the regulators of the markets that are fragmented. "Whereas equities or corporate bonds are overseen by a primary regulator (the SEC), Treasuries are supervised by five or more major agencies, none of which has lead status. The Treasury writes the rules, the Federal Reserve Bank of New York (N.Y. Fed) facilitates debt auctions, the SEC and the Financial Industry Regulatory Authority (FINRA) supervise securities firms that trade Treasuries, the Fed monitors banks, and the Commodity Futures Trading Commission (CFTC) oversees the derivatives markets linked to Treasuries."

Though this kind of fragmentation is typical of the US administrative state, it is highly dysfunctional in the case of a market as large, dynamic and essential as the Treasury market. Yadav joins other academics, notably Darrell Duffie of Stanford, in calling for central clearing to achieve greater transparency and security in trading. Her conversation with David Beckworth on his Mercatus podcast makes for great listening.

As The Economist neatly summarized the options, reform entails one of three options: "allowing the banks to trade more bonds with investors (by loosening reserve requirements on the banks - their preferred option;) ), let investors trade more bonds with each other (with some kind of clearing or improved trading mechanism), or let investors trade or swap more bonds with the Federal Reserve (by way of a widened repo facility)."

So important is the US Treasury market that it has attracted the attention of the G30 and the Financial Stability Board that advises the G20 and the IMF has also chimed in (as linked above).

***

The US authorities are not oblivious to the need for reform. The 2020 crisis was serious.

The Inter-Agency Working Group for Treasury Market Surveillance (IAWG), which was formed in 1992 after the Salmon brothers auction bidding scandal convenes staff from the U.S. Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York (FRBNY), the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC), has taken on task of coordinating reform discussions across the different branches of government.

The most consequential recommendations to date have come from Gary Gensler and the SEC. The SEC is pushing for an extension of central clearing both in Treasury Trading and in repo. It also wants to have more oversight over the firms involved in the market. Earlier this year it proposed that all firms that trade more than $25bn in Treasuries per month to, in future, be registered and regulated as dealers. This has triggered furious blowback back from market makers, investment funds and other firms — almost everyone but the primary dealers, who are already heavily regulated - who all denounced the suggestions as dangerous. They will cause key actors to limit their involvement thus deepening the liquidity problems.

Given the asymmetry of information between market participants, regulators and journalists, and given the lack of overall information, the Treasury market is one in which forming an independent judgement is truly difficult.

And in any case as Alexandra Scaggs of FT Aphaville has noted, tinkering with regulations affecting one group of market participants alone is a partial fix at best. "There isn’t much the SEC can do about high levels of Treasury issuance and economic uncertainty (that’s the job of Treasury, Congress and the Fed). But it can expand its surveillance into Treasury markets to get a better idea of who these price-sensitive traders are, and put de facto limits on leverage. If the goal were solely to create a robust Treasury market structure independent of political pressures, which is surely a fantasy in the US, regulators could be focusing on systemic solutions to deal with funding costs in times of crisis. They could look into clearing solutions, or make more policy about countercyclical changes in dealer regulations. But if regulators are instead using the Pottery Barn rule, the hedge-fund focus makes perfect sense."

A conference will be held on November 16th (tomorrow) with industry players and experts at New York Fed to address the issues.

***

Will there be a market incident before new regulations come in place? It cannot be ruled out. But if it were to occur, we already know how it would be contained. The Fed would buy assets and offer expanded repo facilities to all comers. That is what all the central banks did in 2020. It is what the Bank of England briefly did after the nasty incident with Trussonomics. But if this is the future, it raises the question: are we on a ratchet in which macroeconomic shocks and weak market structure force central banks repeatedly to intervene? Each time they expand their balance sheets and flush liquidity into the system, expanding commercial bank reservers. Then, when they seek to reverse course and “normalize”, they unleash market stress, which causes them to intervene again.

That appeared to be the case in 2019, when Jerome Powell’s first attempt at tightening ended in the repo market shock of September. If we are repeating that cycle now, it forces us to ask: why is it so hard to normalize? Why is it so hard to reverse QE with QT? The answer provided by Raghuram G. Rajan and Viral Acharya in a project syndicate column, and with co-authors in several other papers, is that expanding and shrinking reserves is not symmetrical. It is not symmetrical because of the way that commercial banks respond to the increase in their reserves during the expansionary phase of QE.

When the Fed buys bonds, it does so in exchange for reserves. The bonds that the banks sell to the Fed come from customers who end up with deposits at the banks. The banks make a small interest margin on this trade. But as highly incentivized profit-driven businesses they cannot be satisfied with these slim pickings so they go in search of bigger business. "commercial banks have created additional revenue streams by offering reserve-backed liquidity insurance to others. This generally takes the form of higher credit card limits for households, contingent credit lines to asset managers and non-financial corporations, and broker-dealer relationships that promise to help speculators meet margin calls (demands for additional cash collateral)"

And that is what creates the ratchet effect. The commercial banks become more vulnerable to shocks due to their exposure to contingent credit lines. But when the central banks wants to carry out normalization and shrink reserve, the banks are slow to reel in their profitable lines of new business, putting further stress on their balance sheets. If things get rough they can, after all, rely on being able to sell more Treasuries and if that market freezes up, they will count on the Fed to ride to the rescue.

As Rajan and his colleagues point out, normalization after post-2008 QE may never have happened. But history is moving fast. In the wake of second round of gigantic balance sheet expansion we are now embarked on serious monetary tightening, and not just in the US. The stakes are high. A UK-style “incident” played out in the US Treasury market would rock the global financial system.

Adam Tooze, "Chartbook #172: Finance and the Polycrisis (3) US Treasuries - how fragile is the world's most important market?,"Chartbook, November 15, 2022, https://adamtooze.substack.com/p/chartbook-172-finance-and-the-polycrisis

Chartbook #172: Finance and the Polycrisis (3) US Treasuries - how fragile is the world's most important market?

If there is one financial market that could put in doubt the stability of the entire global financial system it is the $23 trillion US Treasury market.

"...Housing wealth increased by nearly $9 trillion between the first quarter of 2020 and the second quarter of 2022, more than 82 percent through price gains rather than an increase in the housing stock. Plausible estimates of the direct impact on housing wealth suggest that a pessimistic scenario—with a real price correction of 15-20 percent—could shave as much as 0.5-0.7 percentage points from real personal consumption expenditures...."

Skimming U.S. Housing Froth a Delicate, Daunting Task

U.S. house prices appreciated a remarkable 94.5 percent from first quarter 2013 to second quarter 2022—a 60.8 percent rise after adjusting for inflation. The magnitude of the increase is even larger than that of the preceding housing boom, from first quarter 1998 to second quarter 2007.

House prices have risen especially rapidly since the pandemic began—from first quarter 2020 to second quarter 2022—accounting for roughly 40 percent of the decade-long appreciation. Measures of profitability (price to rent) and affordability (price to income) have also jumped in the past two years, past historic highs dating back to first quarter 1975.

This unprecedented pandemic boom poses an outsized risk for the U.S. economy, pressuring housing rents and, consequently inflation, higher. The possibility of a sharp price correction leading to an economic contraction—were one to materialize—would further complicate Federal Reserve inflation-fighting efforts.

Housing Demand Outstripped Supply During Pandemic

Fundamental forces—whether temporary or more persistent—spurred the initial house price surge. Robust disposable income supported by pandemic-related fiscal stimulus and cheap credit boosted consumer demand, while supply-chain disruptions, COVID-19-related lockdowns, and rising labor and raw construction materials costs pushed supply lower.

Pandemic-induced lifestyle changes—work-from-home arrangements and internal migration—also help explain why demand so outpaced housing supply early on.

A housing boom—such as the pandemic-era run-up—becomes frothy when the belief becomes widespread that today’s robust price increases will continue unabated. If many buyers and investors share this belief, purchases arising from a “fear of missing out” (FOMO) further drive up prices and reinforce expectations of strong (and accelerating) future gains beyond what fundamentals could justify.

This self-fulfilling mechanism leads to exponential price growth until a price correction inevitably occurs.

COVID-Era Boom Became Bubbly

Economists often disagree on the fundamental value of housing and what causes expectation-driven bubbles. There is greater agreement on how to identify unsustainable exponential growth—a symptom of a bubble—in the data.

A novel empirical approach is based on so-called exuberance statistics. These measures can help detect if and when housing market indicators—quarterly real house prices, the house price-to-rent ratio and the house price-to-income ratio—start growing exponentially (Chart 1). An exuberance statistic above the 95 percent threshold signifies 95 percent confidence of abnormal unsustainable behavior in the underlying data series. Such episodes are identified in all charts with varying grades of shaded bars.

Moreover, the latest statistics from second quarter 2022 closely parallel the preceding housing bubble, with the data once again showing evidence of explosive behavior in the price-to-rent and price-to-income ratios as well. Accordingly, the pandemic surge before summer 2022 exhibited widening symptoms of a FOMO-driven bubble, one that extends beyond the U.S.

Monetary Policy’s Role Easing Housing Booms

The relatively high number of new houses currently under construction can be a silver lining since supply catching up with demand can take some air out of the market and curb housing affordability woes. However, completions continue to lag. Recent data also show slowing housing sales and softening prices as borrowing costs surge, easing market pressure and, perhaps, enabling builders to chip away on order backlogs.

The share of mortgage debt service payments as a percent of personal disposable income stood at a historically low 3.9 percent in second quarter 2022. This remains well below the unsustainably high range of 6-7 percent reached at the peak of the last housing boom during 2005-07 (Chart 2). The mortgage share of income is poised to rise given the rapid increase of the 30-year mortgage rate―from 3 percent to above 6 percent at the end of third quarter 2022―induced by Fed monetary policy tightening since March 17, 2022. Rapidly rising mortgage rates have contributed to plummeting mortgage loan applications and declining housing sales.

Housing Poses Vulnerability for the U.S. Economy

The red-hot pandemic-era housing market poses significant risks to the Fed’s dual mandate of price stability and maximum sustainable employment.

On the inflation side, the four-quarter change in asking rents climbed to 16 percent in second quarter 2022, modestly slowing to 12.2 percent in the third quarter, reflecting house price increases, according to Zillow data. The Bureau of Labor Statistics’ rent of shelter—a broad measure of household rental costs and a component of the Consumer Price Index (CPI)—reacts with a lag given that landlords’ asking rents are increased gradually as leases turn over. Even so, rent of shelter climbed to 6.2 percent in third quarter 2022—the sharpest rent increase since at least the early 1990s—and pushing overall CPI inflation higher (Chart 3).

Housing wealth increased by nearly $9 trillion between first quarter 2020 and second quarter 2022, more than 82 percent through price gains rather than from an increase in the stock of housing (Chart 4).

To complicate matters, the pandemic price boom has also widened wealth inequality since homeownership is the primary driver of household wealth

Is a Major Housing Correction Unavoidable?

In the current environment, when housing demand is showing signs of softening, monetary policy needs to carefully thread the needle of bringing inflation down without setting off a downward house-price spiral—a significant housing sell-off—that could aggravate an economic downturn. Increasing mortgage rates, which follow from higher Fed policy rates, reduce the risk of prolonging the house price boom.

A gradual unwinding of the pandemic housing excesses can occur if policymakers can quell inflation without putting buyers under too much stress and can slow house price and rent increases while keeping underwater mortgages (housing worth less than what is owed) from rising.

Households and financial institutions are in better shape than during the housing boom and bust in the mid-2000s, likely providing more of a cushion to withstand some of the consequences of a negative wealth effect, were one to materialize.

However, after a housing boom partly driven by pandemic-era FOMO beliefs, cooling market participants’ expectations is key to shifting house prices toward a more sustainable path and avoiding the peril of a disorderly market correction.

A severe housing bust from the frothy pandemic run-up isn’t inevitable. Although the situation is challenging, there remains a window of opportunity to deflate the housing bubble while achieving the Fed’s preferred outcome of a soft landing. This is more likely to happen if the worst-case scenario of a price-correction-induced economic downturn can be avoided.

“…Most of this decline is attributable to the aging of the population and a reduction in part-time employment among workers aged 70 and older. The decline in the overall employment rate was 0.89pp. Of this decline, the aging effect accounts for 0.58pp, about two-thirds of the total decline. The “failure” of employment to rebound to pre-pandemic levels is not primarily explained by some decreased “willingness to work”, but rather by the steady aging of the population….”

Preston Mui, “Who is Driving the Labor Shortage? Part-time Over-70 Workers,”Employ America, November 4, 2022, https://www.employamerica.org/blog/who-is-driving-the-labor-shortage/

Who is Driving the Labor Shortage? Part-time Over-70 Workers

A Labor Supply Shock?

Much ado has been made about the shortfall in the headline employment-to-population ratio and the headline labor force participation rate of late. Many have claimed that recent wage and price pressures trace back to a “labor supply shock”. Some have even tried to make the more nuanced claim that this disappointment holds even after controlling for demographic effects, with specific attention given to workers aged 55 and older. The employment rate of this group in October was 37.9%, compared to its pre pandemic high of 40.5% in July 2019.

This morning, the Bureau of Labor Statistics released the new Employment Situation Report. As was true in previous months, the data show a strong recovery since the pandemic recession, although there are signs of weakening in the household survey. The prime-age (25-54) employment-to-population ratio fell from 80.2% to 79.8%, slightly lower than its pre-pandemic high of 80.5%. The all-age employment-to-population, however, has not seen the same recovery since the pandemic started. The labor force participation data shows the same pattern.

Some have pointed to stagnant employment rates among older workers as evidence of a labor supply issue. However, in reality, most of this decline is attributable to the aging of the population and a reduction in part-time employment among workers aged 70 and older. In the context of what counts as a strong employment recovery from a pandemic with disparate impacts on the elderly, it is not apparent that there has been critically “missing labor supply” from those older workers that can—or should—be brought back.

“Early retirements” in this older population have been explained in various ways: concerns over COVID, strong balance sheets after a strong fiscal response and stock market returns, or a reevaluation of work-life balance preferences. At the same time, there are concerns that early retirements in this group are presenting a significant drag on labor supply. In a speech last month, Lisa Cook cited early retirements as a cause of stagnant labor supply. Jay Powell has cited “subdued” labor supply as one source of labor market tightness (and implicitly, inflation) in both his May and June FOMC statements.

Labor demand is very strong, and, while labor force participation has increased somewhat, labor supply remains subdued.
– Jay Powell, May 4, 2022 FOMC press conference

In the post, I explain why concerns over these so-called “lost workers” as a source of labor supply issues are overblown. The predominant explanation for the employment shortfall is the aging of the workforce, not lower employment rates within age groups. The shortfall of older workers is primarily concentrated among workers over the age of 70, and specifically those who were working part-time. While there have been economically consequential acute labor shortages in particular sectors—like trucking, construction, and oilfield services—any wage, price, and bottleneck pressures in these sectors cannot be credibly attributed to the shortfall in employment and participation among these elderly cohorts.

Decomposing the Shortfall in Employment

What then accounts for the overall shortfall in employment? To answer this question, I decompose the change in the overall employment rate between before the pandemic and now into an “aging effect” and an “employment effect.” The aging effect is the change in the overall employment rate that is attributable to the changing age composition of the population, holding the employment rates of age groups constant. Conversely, the employment effect measures the effect of changes in the employment rates of age groups, holding the age composition constant.

The chart below shows the decomposition of the employment shortfall into these aging and employment effects. Importantly, I use narrow age bands to calculate the aging and employment effects, which allows me to distinguish between older working-age workers (55-64) and the 65+ population. Since the narrower employment rate data is only available on a non-seasonally adjusted basis, I compare the average of the three months ending October, 2019 to the three months ending October, 2022.

The decline in the overall employment rate was 0.89pp. Of this decline, the aging effect accounts for 0.58pp, about two-thirds of the total decline. The “failure” of employment to rebound to pre-pandemic levels is not primarily explained by some decreased “willingness to work”, but rather the steady aging of the population.

The remainder of the decline in employment, 0.30pp, is accounted for by the employment effect. This employment effect is in turn mostly explained by a decline in the employment rate of the 65+ population. The decline in the employment of workers between the ages of 55 and 64 (workers who would potentially be taking “early retirement”) accounts for only a minimal part of the overall decline.

When one takes a closer look at the decline in employment rates in older cohorts, the proposition that the sidelining of these workers is a significant source of “labor shortages” becomes even more strained. In the chart below, I repeat the decomposition exercise for the decline in 55+ employment rates.

As with the overall population, the fall in employment rates among the 55+ population is mostly due to aging within this population. The contribution of the employment effects is concentrated mostly among the oldest among the older workers, those above the age of 70, not the workers between 55 and 69 mostly characterized in the media as affected by “early retirements.” If employment rates of workers aged 55-69 returned to pre-pandemic levels, the overall employment-to-population ratio would only increase by 0.075pp, less than one-tenth of the overall shortfall.

Full-time Employment Shows a Strong Recovery

Another reason the labor supply shortage story is overstated is that full-time work (35 or more hours a week) has now nearly fully recovered, and the shortfall in employment is predominantly due to lower rates of part-time work (less than 35 hours). The proportion of the population (3-month moving average) working full-time is only 0.4pp lower than three years ago, while part-time work is 0.6pp lower.

Data on part-time vs. full-time work for older workers is not as disaggregated or frequent as the overall data, but what is available suggests that the decline in employment among older workers is also mostly due to declines in part-time, not full-time, work. The proportion of Americans 65 and older usually working full-time actually increased between 2019 and 2021 (annual averages) by 3.3%, from 6.42 million to 6.63 million. Meanwhile, the number of part-time workers in this age range fell by 11.0% in the same period, from 3.93 million to 3.49 million.

To sum up: the all-age employment-to-population ratio has not caught up to pre-pandemic levels for reasons not primarily due to work disincentives, fiscal support, or nebulous “quiet quitting” phenomena. Rather, the bulk of the fall in employment is attributable simply to the aging of the workforce. The remainder of the shortfall is better characterized by a reduction in septuagenarians working part-time jobs, not early retirement of the working-age.

While there might be acute labor shortages in particular areas, such as pilots or construction workers, these are probably not shortages that are likely to be resolved by “bringing back” part-time elderly workers. In short, it does not appear that there is a substantial labor supply issue in an aggregate sense.

Moreover, this decomposition exercise clearly shows just how successful the labor market recovery has been over the last two years. The sluggish labor market recovery following the Great Recession left many workers on the sidelines for years. Thankfully, the COVID recovery has been much more rapid, due in large part to the strong fiscal and monetary policy response.

However, the October jobs report shows worrying signs of a deteriorating labor market. The prime-age employment-to-population ratio continued to fall from 80.2% to 79.8%. Unemployment ticked up to 3.7%, and full-time employment fell. If trends continue, we risk giving back the gains from the strong labor market recovery. Policymakers need to take this risk seriously.

Jay Powell (and others) have framed the labor shortfall in terms of labor force participation, rather than employment. A similar exercise decomposing the shortfall in labor force participation shows the same story as this decomposition for employment.

“…Democrats appeared to have done particularly poorly among Hispanic men in 2022. In the VoteCast data, Democrats carried this group by a scant 6 points (51-45). Compared to 2018, Democratic Hispanic working-class support is down 20 margin points, more than double the decline among Hispanic college voters (9 points). AP VoteCast estimates the decline in Democrats’ advantage among the nonwhite working class as 14 points between 2020 and 2022, 23 points between 2018 and 2022, and (splicing in some Catalist data, which overlap pretty well with VoteCast data where they overlap) an astonishing 33 point drop between 2012 and 2022….”

Ruy Teixeira, "Democrats’ Hispanic Problem: The Sequel,"The Liberal Patriot, November 17, 2022, https://theliberalpatriot.substack.com/p/democrats-hispanic-problem-the-sequel

Democrats’ Hispanic Problem: The Sequel

Democrats are feeling pretty good about themselves these days after a 2022 election that went way, way better than they (and most observers) thought it would. Those on the Democratic left, in particular, are congratulating themselves that they were right about…well, everything. Ezra Levin, who co-founded the activist progressive group, Indivisible said: "The great thing about having your strategy being proven correct is that you don’t have to rethink your strategy…We would have, if the red wave materialized. But it didn’t have the potency that we thought."

God forbid anyone should do any rethinking. That would never do.

The fact remains, however, that while they held the Senate (and may possibly pick up a seat), they lost the House, as well as the nationwide popular vote by 3-4 points. That’s a swing of 7-8 points toward the Republicans compared to Biden’s 4 point national advantage in 2020. The Senate map for the Democrats in 2024 looks absolutely terrifying: Democrats will have to hold seats in a wide range of red and purple states—Arizona, Maine, Michigan, Minnesota, Montana, Nevada, Ohio, Pennsylvania, Virginia, Wisconsin and West Virginia. The Republican seats that will be up are all in solid GOP states, with the possible exceptions of Texas and Florida (and we saw what just happened there). Plus there’s no guarantee that the 2024 Democratic nominee—likely Biden—will get to run again against the Democrats’ preferred opponent, Trump. It could be someone much tougher to take down.

In light of this, it’s worth considering the possibility that Democrats did not, in fact, fix all their problems in 2022 and that some of these may be lurking beneath the surface to undermine their chances—perhaps fatally—in 2024. One such problem is the Democrats’ Hispanic voter problem. In 2020, Democrats’ advantage among Hispanic voters declined nationwide by 16 points relative to 2016. Democrats had hoped to stop the bleeding in 2022. Did they?

It does not appear so. Prior to the election, the AEI demographics tracker, which averages poll subgroup results, found the Democratic Congressional margin among Hispanic voters consistently 7-9 points below its 2020 level and 17-19 points below its 2018 level. Results from AP/NORC VoteCast indicate that the drop in the 2022 election was actually larger than that foreshadowed by the pre-election data. These data show Democrats carrying Hispanics nationwide by just 56-39 in 2022, a 12 point decline in margin relative to 2020 (18 points relative to 2018). For what it’s worth, the less-reliable network exit polls, show an identical decline in Hispanic support between 2020 and 2022.

Digging more into the available data, some other troubling signs can be discerned beneath this broad national trend (all data from VoteCast except election returns).

1. Democrats appeared to have done particularly poorly among Hispanic men in 2022. In the VoteCast data, Democrats carried this group by a scant 6 points (51-45).

2. Democrats did worse among Hispanic working class (noncollege) voters than college voters. They carried Hispanic working class voters by just 15 points, compared to 21 points among their college-educated counterparts. Compared to 2018, Democratic Hispanic working class support is down 20 margin points, more than double the decline among Hispanic college voters (9 points).

3. With a few exceptions like Nevada, Democratic decline in Hispanic support can be seen across states. The most striking example of this is in Florida where DeSantis carried the Hispanic vote by 13 points, a 22 point swing from Biden’s 9 point margin among this group in 2020. He carried heavily Hispanic Miami-Dade county, historically the Democrats’ firewall, by 11 points. He carried Osceola County by almost 7 points—a county where Puerto Ricans, among the most Democratic of Hispanic subgroups, loom large. Shockingly, statewide DeSantis actually split the Puerto Rican vote 50-50 with Democrat Charlie Crist.

4. Democrat Val Demings also lost the Hispanic vote in Florida to Marco Rubio by 11 points. And statewide Democrats lost the Hispanic House vote by 7 points to the Republicans.

5. In Texas, Republicans got 43 percent of the statewide House vote among Hispanics, losing it by only 10 points to the Democrats. Beto O’Rourke did somewhat better than Biden in the Rio Grande Valley but still carried Hispanics statewide by just 14 points.

6. The poor showing of Democrats in the Hispanic Texas House vote was driven by working class Hispanics. They gave Democrats a mere 6 point margin statewide (51-45) compared to 24 points among college Hispanics (61-37). But working class Hispanics are three-quarters of the Texas Hispanic vote.

7. In Arizona, the GOP got 41 percent of the statewide House vote among Hispanics, cutting their deficit with this demographic to 13 points. Democrats’ House margin was down 6 points from Biden’s margin among this group in 2020. Katie Hobbs also ran behind Biden in her Hispanic support while Mark Kelley did a little better. But Kelley’s healthy margin of victory (5 points) is clearly attributable to a sharp improvement in support among white college graduates relative to Biden.

8. Even in California, Democratic House candidates in 2022 ran 11 points behind Biden’s margin in the state in 2020. This decline can be illustrated by looking as some heavily Latino CDs in Los Angeles County (vote counts ongoing): CA-31, Biden +31, 2022 House +16; CA-35, Biden +28, 2022 House +12; CA-38, Biden +30, 2022 House +13; CA-42, Biden +46, 2022 House +34.

These data suggest Democrats are far from out of the woods in terms of their Hispanic voter support. In fact, they indicate the problem is getting worse. More broadly, Democrats would be well-advised to look at these results in the context of their ongoing decline in working class support among nonwhites. AP VoteCast estimates the decline in Democrats’ advantage among the nonwhite working class as 14 points between 2020 and 2022, 23 points between 2018 and 2022 and (splicing in some Catalist data, which are consistent with VoteCast data where they overlap) an astonishing 33 point drop between 2012 and 2022.

I’d say that qualifies as a problem—and one that’s very, very far from being fixed.

“…The main mechanism through which house prices affect non-shelter inflation is through shifts in demand or changes in markups arising from housing wealth effects. A back-of-the-envelope calculation based on our regression estimates suggests that house price growth could explain about 1/3 of the consumer price index (CPI) increase, excluding housing services between February 2020 and February 2022. Following many months of annualized house price growth rates of 15-25%, recently, house prices have decelerated sharply. The acceleration of house prices early in the pandemic preceded the acceleration in the CPI. The correlations we document in this note suggest that inflation should step down somewhat in the future, given the sharp slowdown in house price growth and absent other inflationary shocks…”

Another possibility is that house price growth is associated with the strength of the local labor market, and it is local labor market conditions that influence inflation, not house price growth directly. The results in column 3, however, show that the estimated elasticity of non-housing inflation to house price growth is little changed when adding the change in the unemployment rate as a control.2 Also, the coefficient on house price growth is similar when controlling for the growth in average weekly wage changes or the total wage bill from the Quarterly Census of Employment and Wages (not shown).

Over our sample period, Congress passed massive fiscal stimulus, and the generosity of the income support from these stimulus programs likely varied across metro areas. It is possible that local income growth drove both house price growth and inflation. In column 4, we control for the growth in personal income as measured by the BEA, which includes income that people get from government benefits.3 Personal income growth is not significantly associated with inflation, and again the estimated elasticity of inflation to house price growth is little changed when adding local income growth as a control. Next, we consider the possibility that the housing wealth effect on inflation that we estimate may be correlated with a stock market wealth effect. Like house prices, stock prices soared in 2020 and 2021. We proxy for local exposure to increases in stock market wealth with the per-capita pre-pandemic average interest and dividend income in the metro area calculated from the 2019 IRS SOI tax data. Column 5 shows the results are little changed when this variable is added as a control. Column 6 shows results with controls for pre-pandemic median household income, share of households with college education, the homeownership rate, and median age - potential alternative proxies for exposure to the stock market boom. The results are similar.

Column 7 shows the results when all controls are added. None of the controls are individually significant, and the estimated elasticity of inflation to house price growth remains sizable and significant. Finally, column 8 includes as a control the log change in market-rate rents, available for 21 of the metro areas in our sample. The coefficient on house price growth remains of a similar magnitude as in other specifications and remains significant. This is further evidence that the coefficient on house price growth is primarily measuring housing wealth effects rather than confounding factors, as changes in market rate rents should reflect various unobserved factors associated with housing demand and supply that could be correlated with house price growth and inflation. Indeed, changes in rents are highly correlated with changes in house prices, inflation, and population.

In sum, looking across all the columns in the table, the estimated elasticity is remarkably stable considering the small sample size. A natural question is what is driving the variation in house prices across cities. While pinpointing the causes of house price changes is beyond the scope of this Note, some factors that could drive cross-sectional variation in house price growth that are plausibly unrelated to inflation include housing supply elasticity, the increase in demand for second homes from out-of-town buyers, or the pre-pandemic work-from-home share (Mondragon and Wieland, 2022). We explore instruments for house price growth in future work.

2.1. Inflation by type of goods or services

Table 3 shows results separately for inflation of durable goods, nondurable goods, services excluding shelter, and shelter services. We find the strongest effects of house price growth on inflation for services excluding shelter, nondurable goods and shelter services. For durable goods, we estimate a small or very noisy effect of house price growth on inflation. House price growth may not have a clear effect on durable goods inflation because durable goods are less likely to be produced locally (e.g. motor vehicles), and therefore, firms selling durable goods may set prices nationally. It is possible that house price growth increases inflation for durable goods, but trade reduces differences across metro areas. Our cross-sectional estimation strategy cannot identify this type of aggregate effect.

2.2. Comparing the pandemic inflation-house price growth relationship with its historical one

An increase in non-housing demand, induced by increases in housing wealth, is likely to be more inflationary when supply is more constrained. Since the second half of 2020 through the start of 2022, supply conditions have seemed generally tight, with retailers reporting low inventories and producers reporting slow delivery times amid shortages of inputs used in production. Hence, our prior is that demand effects were likely more inflationary from February 2020 to February 2022 than in other periods.

Table 4 shows results from a regression of non-shelter inflation on house price growth using metro area observations pooled across all two-year periods between February 2000 and February 2022. The regression includes an interaction between house price growth and a dummy variable for the 2020 to 2022 pandemic period allowing us to estimate the relation between house prices and inflation separately in the pre-pandemic and pandemic periods. The results in column 2 include metro area fixed effects and the results in column 3 include both metro area fixed effects and time period fixed effects. The results across all three columns show that the association between inflation and house price growth was unusually strong during the pandemic. Indeed, in the two decades prior to the pandemic, there was essentially no correlation between house price growth and non-shelter inflation for these metropolitan areas.

The main mechanism through which house prices would affect non-shelter inflation is through shifts in demand or changes in markups arising from housing wealth effects. To provide evidence consistent with these mechanisms, we use data on credit card spending from the Federal Reserve Board's FR Y-14M reports. These reports require large U.S. bank holding companies, with at least $100 billion in total assets, to report information on individual credit card accounts on a monthly basis. For each metro area, we construct the change in nominal spending as measured by the flow of new purchases on credit cards between January-February 2020 and January-February 2022.5 For the 23 metro areas for which we observe CPI, we also construct a change in real spending by deflating nominal spending with the local CPI less shelter over the same time period.

Table 5 shows results of regressions similar to equation 1, replacing the dependent variable with spending growth. The first column shows that the estimated nominal spending elasticity to house price growth is 0.58 for the same small sample of metro areas used in Table 2. Column 2 shows the elasticity is little changed when the controls are added to the regression. The third and fourth columns show the real spending elasticity is strongly positive but smaller than the nominal elasticity, consistent with the positive association between inflation and house price growth shown in Table 2.

The positive real spending response we estimate suggests a role for increased aggregate demand in explaining the positive effect of house price growth on inflation during the pandemic. Also, the substantial price response we find together with the evidence in Table 4 is consistent with tight supply conditions preventing firms from providing additional goods and services without raising prices. The price response may also be partly explained by households becoming less sensitive to price increases such that firms raised mark-ups.

Columns 5 and 6 show the elasticity of nominal spending in the full sample of 896 metropolitan and micropolitan areas covered by the Y-14M data. The estimated elasticities for the large sample are quantitatively similar to those estimated for the small sample. If we assume that 60-75 percent of the nominal spending effect in the large sample reflects an increase in real spending, consistent with the split we directly estimated for the small sample, then columns 5 and 6 imply an elasticity of non-shelter inflation with respect to house price growth of 0.125 or 0.145 for the large sample, very similar to the point estimates in Table 2 for the small sample.

4. Role of house price growth in explaining recent inflation

We can use our estimates to calculate the contribution of house price growth to national, non-shelter inflation between February 2020 and February 2022. Multiplying the increase in national house prices over this time period by the elasticity estimate from column 1 of Table 2, we find that house price growth increased the national, non-shelter CPI by 4 log points, which is 39 percent of the total increase in national, non-shelter CPI over this time period. Even at the lower bound of the 90 percent confidence interval around our elasticity estimate, house price growth still explains 13 percent of the increase in national, non-shelter CPI.

The calculation is back-of-the-envelope for a few reasons. First, it extrapolates based on a linear relationship between house price growth and inflation estimated using a sample of metro areas where house price growth was high for every observation. Still, under a very conservative scenario that assumes zero effect of house price growth on inflation until house price growth reaches the minimum level in our sample, house price growth explains 19 percent of the increase in non-shelter inflation CPI. Second, house price growth could increase price inflation for some goods or services only at the national level and not differentially by metropolitan area. Our back-of-the-envelope calculation cannot account for any national effects and thus could understate the contribution of house price growth to non-shelter inflation. Third, we cannot rule out a role for some omitted variable or measurement error to bias our estimated elasticity up or down.

Finally, the correlations we document in this note have some implications for the current inflation outlook. Following many months of annualized house price growth rates of 15-25 percent, recently house prices have decelerated sharply. The acceleration of house prices early in the pandemic preceded the acceleration in the CPI. The correlations we document in this note suggest that inflation should step down somewhat in the future, given the sharp slowdown in house price growth and absent other inflationary shocks.

References

Adams, Robert M., Vitaly M. Bord, and Bradley Katcher. 2021. "Why Did Credit Card Balances Decline so Much during the COVID-19 Pandemic?" Board of Governors of the Federal Reserve System (U.S.) FEDS Notes 2021-12-03-3.

Aladangady, Aditya. 2017. "Housing wealth and consumption: Evidence from geographically-linked microdata." American Economic Review, 107(11): 3415-46.

Dias, Daniel A, and João B Duarte. 2019. "Monetary policy, housing rents, and inflation dynamics." Journal of Applied Econometrics, 34(5): 673-687.

Guren, Adam M, Alisdair McKay, Emi Nakamura, and Jón Steinsson. 2021. "Housing wealth effects: The long view." The Review of Economic Studies, 88(2): 669-707.

Hazell, Jonathon, Juan Herreno, Emi Nakamura, and Jón Steinsson. 2022. "The slope of the Phillips Curve: evidence from US states." The Quarterly Journal of Economics, 137(3): 1299-1344.

Horvath, Akos, Benjamin S. Kay, and Carlo Wix. 2021. "The COVID-19 Shock and Consumer Credit: Evidence from Credit Card Data." Board of Governors of the Federal Reserve System (U.S.) Finance and Economics Discussion Series 2021-008.

Kaplan, Greg, Kurt Mitman, and Giovanni L. Violante. 2020. "Non-durable consumption and housing net worth in the Great Recession: Evidence from easily accessible data." Journal of Public Economics, 189: 104176.

Mian, Atif, Kamalesh Rao, and Amir Sufi. 2013. "Household balance sheets, consumption, and the economic slump." The Quarterly Journal of Economics, 128(4): 1687-1726.

Mondragon, John, and Johannes Wieland. 2022. "Housing Demand and Remote Work."

Stroebel, Johannes, and Joseph Vavra. 2019. "House prices, local demand, and retail prices." Journal of Political Economy, 127(3): 1391-1436.

________________________________

1. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. The authors thank Ari Gelbard, Raghav Warrier, and Adithya Raajkumar for excellent research assistance. Return to text

2. While changes in the unemployment rate are not significantly associated with inflation excluding shelter in this sample, they are negatively associated with shelter inflation. Hazell et al. (2022) find that the regional Phillips curve for rents is substantially steeper than for inflation excluding shelter. Return to text

3. Because the BEA data at a metro-area level are only available for 2020, we use personal income growth for 2020 relative to 2019. Since the progressivity of fiscal support in 2021 was similar to 2020 generally, our measure likely captures broad cross-sectional patterns in earnings and transfers over this period. Return to text

4. For more information, seehttps://www.bls.gov/cpi/factsheets/owners-equivalent-rent-and-rent.htmReturn to text

5. Purchases on credit cards that do not become revolving balances are still included in our data. Information in the Y-14 is anonymized and does not contain transaction-level detail. Accounts associated with the same consumer cannot be linked across or within reporting banks. The large banks reporting to the FR Y-14M account for a high percentage of total credit card spending. For other work using this data, see Adams, Bord and Katcher (2021); Horvath, Kay and Wix (2021). Return to text

Aditya Aladangady, Elliot Anenberg, and Daniel Garcia, "House Price Growth and Inflation During COVID-19"Federal Reserve Board, https://www.federalreserve.gov/econres/notes/feds-notes/house-price-growth-and-inflation-during-covid-19-20221117.html

House Price Growth and Inflation During COVID-191

1. Introduction

House prices have risen rapidly during the pandemic, creating $9 trillion in owner occupied housing wealth between the first quarter of 2020 and the first quarter of 2022. Both housing and non-housing inflation also moved up over this time period to its highest level in many decades. This note considers whether the large increase in housing wealth has been an important contributor to non-housing inflation during the pandemic.

There are two main channels through which increases in housing wealth can contribute to non-housing inflation. First, the increase in housing wealth can stimulate additional consumption among existing homeowners, either because they feel wealthier or by relaxing borrowing constraints (Guren et al., 2021; Mian, Rao and Sufi, 2013; Aladangady, 2017). This shift in aggregate demand can result in non-housing inflation, especially when the slope of the aggregate supply curve is steep, as may have been the case during the pandemic. Second, homeowners may become less price sensitive as they become wealthier, allowing some firms to respond to a less price-elastic demand curve by raising markups and prices (Stroebel and Vavra, 2019).

This note documents a strong positive association between non-housing inflation and house price growth across major metropolitan areas during the first two years of the pandemic. Also, we show this correlation is much stronger than in recent history. The association during the pandemic does not appear to be driven by other leading omitted variables that could be correlated with local house price growth and inflation, such as changes in the local unemployment rate or population growth. In addition, we find a strong cross-sectional correlation between house price growth and both nominal and real credit card spending.

Taken together, our results provide suggestive evidence that house price growth has been an important contributor to inflation during the pandemic, in part by shifting aggregate demand along a steeper-than-normal aggregate supply curve. A back-of-the-envelope calculation based on our regression estimates suggests that house price growth could explain about 1/3 of the increase in the consumer price index (CPI) excluding housing services between February 2020 and February 2022. At the lower bound of the 90 percent confidence interval around our regression estimate, house price growth still explains 13 percent of the increase in the CPI excluding housing services.

2. Inflation and House Price Growth Across Metro Areas

We estimate the cross-sectional relationship between inflation and house price growth using the regression equation:

(1) Δlog(cpixi)=β0+β1Δlog(hpii)+β2Xi+εi(1) Δlog(cpixi)=β0+β1Δlog(hpii)+β2Xi+εi

where cpixcpix is the CPI excluding housing services for metro area ii, hpihpi is the CoreLogic house price index for metro area ii, XiXi is a vector of other local characteristics, and ΔΔ denotes the two-year change in the variable, February 2022 relative to February 2020.

The CPI is available for the 21 largest metro areas in the country, in addition to Honolulu, HI and Anchorage, AK, which jointly account for about 40 percent of the U.S. population. Table 1 reports summary statistics and sources for the variables used in this analysis.

“….A near-term economic downturn, an extended period of above-target inflation, and a second round of tightening are not discounted in the markets at all.What the markets are now discounting is that the first round of tightening is nearly over, that growth will not slow much and yet inflation will quickly fall to desired levels and that this will allow a cut in interest rates in 2023 and 2024 that restores a normal risk premium in bonds. If you adjust recent equity returns for the portion that is attributable to the rise in discount rates, they are not down. In other words, there has been no discounting of a decline in future earnings. This is corroborated byanalysts’ earnings estimates, which have barely changed post-tightening….”

Bob Prince, “An Update from Our CIOs: Progressing Through the Tightening Cycle,”Bridgewater Associates, October 11, 2022, https://www.bridgewater.com/research-and-insights/an-update-from-our-cios-progressing-through-the-tightening-cycle

An Update from Our CIOs: Progressing Through the Tightening Cycle

Going back before going forward, in 2020-21, aggressively applied MP3 policies stimulated a high level of nominal spending growth that was well in excess of the output capacity of labor, with the difference between them producing a self-sustaining, monetary-induced inflation. In 2022, recognition of this condition led markets to discount a coming rise in interest rates and tightening of monetary policy. The Fed and central banks then followed suit. The speed and magnitude of the tightening has been severe, among the sharpest in the past 60 years. The primary effect of this tightening has been to drive asset yields higher to compete with the higher yield on cash, which drove prices lower through the present value effect. That is pretty much the full explanation for this year’s weak asset markets.

The effect of this tightening on economies has been far less, though not enough time has passed to expect a lot. The effects are coming, and they must come in order for targeted levels of inflation to be achieved. Therefore, the next stage of the tightening cycle is likely to be a significant slowing of economic activity, probably a downturn. Whether the weakening of the economy sufficiently lowers inflation to central banks’ target levels and to the levels that are now discounted in the markets depends on the degree of economic weakness and how long that weakness lasts. And in particular, whether there is a contraction in employment and a material rise in the unemployment rate.

The key linkages are as follows. Inflation is too high because nominal spending growth is far greater than the ability of labor to produce more output. This is amplified a bit by supply issues, but supply is not the problem. Sustainably reducing inflation will require cutting nominal spending growth by about half to around 3% to 5%, which is where it was during the moderate inflation period of the 2000s and 2010s. While this high level of spending growth was initially financed by government credit and money printing, it is now financed by the income that the spending is producing. In other words, it is self-financing via the income that the spending produces, which is the second stage of a monetary-induced inflation.

So, how does a tightening of monetary policy break the cycle? It does so through a number of channels. First, higher interest rates directly reduce debt-financed spending, such as housing and autos, which incrementally reduces income. This has already happened via mortgages and housing, but housing and housing-related spending is too small to be the solution. Second, the rise in interest rates, through the present value effect, lowers asset prices, which reduces wealth, which typically raises the savings rate, which means less spending and less income. Third, higher interest rates and a tightening of credit conditions reroute income from spending to debt service payments. Fourth, income is reduced directly via a contraction in hours worked, a contraction in labor markets. Given the high level of nominal spending and the degree to which it has passed through to wage growth, this fourth lever will be required.

For the tightening to sustainably reduce inflation will require significant impacts on labor income. Labor income is the sum of two parts, hours worked (dominated by headcount) and wages per hour. The tightening will have to first produce a contraction in the number of people working and raise the unemployment rate by enough and for a long enough period of time to reverse the supply/demand imbalance for labor sufficiently to lower the price of labor, i.e., wages. Only after wage growth slows will inflation stabilize at the levels that central banks want and that the markets are discounting.

Up to this point, the appropriate policy response to the environment has been clear, though it came too late. Strong growth and the emergence of a self-reinforcing, high level of inflation required a tightening. Going forward, the policy choices will be far more challenging when the goals of full employment and stable prices are at odds and the contraction in employment has not been sustained for long enough to bring down wage growth. For most central banks, at that stage there is a tendency to pause and see how things transpire. Such a pause tends to give markets a celebratory reprieve, producing a period of very good asset returns and a pickup in growth, both of which conspire to prevent wages and inflation from settling at the desired level, which necessitates the next round of tightening.

A near-term economic downturn, an extended period of above-target inflation, and a second round of tightening are not discounted in the markets at all. What the markets are now discounting is that the first round of tightening is nearly over, that growth will not slow much and yet inflation will quickly fall to desired levels and that this will allow a cut in interest rates in 2023 and 2024 that restores a normal risk premium in bonds. There is a lot of room for markets to be blindsided by what we see as the normal sequence of events which typically follows the conditions that exist today.

This description of conditions is applicable to the US, Europe, the UK, and other developed economies which countered the pandemic via MP3 policies, which boosted incomes via the monetization of government debt. In contrast, conditions in China, Japan, and other economies which resisted this path and instead chose the path of more severe social adjustments are quite different. In those countries, nominal spending growth is at normal levels, which is producing normal inflation rates, which is giving policy makers more latitude to counter economic weakness with stimulative policies that can be executed via combinations of monetary policy, fiscal policy, and macroprudential regulatory policy. China is applying some of that latitude while trying not to overdo it. Japan is sticking with their QQE policies and the targeting of bond yields while experiencing near 2% inflation rates for the first time in years. These more accommodative policies are in contrast to the severe tightening by the Fed, weakening these countries’ exchange rates but stabilizing their asset markets in local currency terms.

Below, we will try to succinctly elaborate on this unfolding story via a brief series of illustrations and charts.

Illustrating the Dynamics at Work

There are two big imbalances that must be resolved to achieve equilibrium conditions. Nominal spending growth is far higher than the output capacity of labor, and nominal spending is also far higher than interest rates. The first condition is why inflation is high; the second condition contributes to the ability of credit growth to sustain the high level of nominal spending until a rise in interest rates is sufficient to bring the level of nominal spending down, converging at a reasonable balance. The following charts illustrate these two disequilibriums.

Asset prices are down this year because asset yields are up, and asset yields are up because the aggressive tightening of monetary policies has driven up the discounted future real yield of cash, which we call the discount rate. The discount rate is the base reference by which all assets are ultimately compared because holding cash is an alternative to holding risky assets. There is a risk curve which is like a yield curve across assets, which reflects the required yield on other assets as risk increases. The following illustration shows how over the past decade central banks managed a progressive decline in the discount rate in stages (1) and (4), which led to the decline in yields on other assets, steepening the risk curve (2) and (5), which induced money to move from cash to assets (3) and (6), driving their yields down. That was the basis of very high returns on assets over this period.

This year’s tightening has reversed that process by driving the discount rate up (7), flattening the risk curve (8), requiring higher yields on all assets (9).

Given these conditions, there has been a reversal in the long-term downtrend in discount rates and real bond yields. This rise in real yields has passed through all assets and supported the dollar relative to gold and other currencies.

If you adjust recent equity returns for the portion that is attributable to the rise in discount rates, they are not down. In other words, there has been no discounting of a decline in future earnings. This is corroborated by analysts’ earnings estimates, which have barely changed post-tightening.

In addition to the rise in real and nominal interest rates, the Fed and other central banks are now contracting balance sheets at a time when government bond issuance remains high, withdrawing liquidity from financial markets and creating a liquidity hole. In the decade since the financial crisis, there has been excess liquidity from central banks buying assets. This buying drove assets up faster than the economy and meant that even with government debt rising, the government debt held by the private sector could stay flat. The private sector didn’t have to buy bonds; they just had to hold on. This is now reversing. For the first time in a while, the private sector must buy new bonds at a massively increasing clip in order for the market to clear. This requires a level of yields at which the private sector desires to buy them, not the yields that central banks want to create and are willing to accept in order to institute their policies.

The table below gives perspective on the magnitude of this liquidity hole. The amount of government debt that will need to be absorbed by the private sector in the coming months is larger than at any time outside of world wars (when the central bank engineered a safe risk premium on bonds) and the global financial crisis.

The impacts of the liquidity hole stretch far beyond the bond market. When a private player buys bonds, they have to either use cash (which they might have otherwise used to buy assets) or sell assets. The consequence is that the liquidity hole is showing up not just in the bond market, but in the equity market and in other assets. The chart below shows the impact we have already seen this year from the liquidity hole trickling through all assets. Looking ahead, this is getting worse, not better.

As we progress through the tightening cycle, what likely comes next is a weakening of economies. The following diagram illustrates where we are in the liquidity cycle, which is the tendency of money to move from assets to cash or from cash to assets. Starting from economic contractions in the pandemic there was an aggressive easing, then the declines in discount rates and risk premiums and rises in asset values, then the pickup in economies, which led to inflation, then the tightening and rise in discount rates in response to that. What comes next is the rise in risk premiums and the weakening of economies.

The charts below show our most timely read of current economic conditions across countries, as well as our leading estimates. China’s divergence from the other developed economies is clear.

Our leading estimates of inflation indicate that economies have not weakened enough for long enough to move inflation rates very far toward central bank targets or what the markets are discounting. Again, China and Japan are experiencing different inflation conditions leading to very different policies and diversifying asset returns.

To put this most recent chapter in the context of the unfolding story, we invite you to revisit our CIO updates from our 1Q 2022 and 2Q 2022 reports.