June 26, 2022 | Issue 21 ** SPECIAL ISSUE **
UNDERSTANDING THE ECONOMY I am taking a break from reporting the crypto news and instead writing this special issue about the economy. I'm doing this for two reasons. First, I won't be tracking the news because I'll be on vacation. I'll be hanging out at the DAOU vineyard, relaxing in San Luis Obispo, and flying in my brother-in-law's four-seater plane with my wife Jody and her sister. And second, I've discovered that it is not possible to understand the crazy dynamics of crypto without having basic knowledge of the economy. We are at a point where we are saying good bye to rising asset prices, stable pricing of consumer goods, a red hot housing market, a rising stock market, record low unemployment, and a crypto market that has outperformed all investments. This issue will help you make sense of the headlines so you can discuss economic conditions with your prospects and clients.
Here we go...
▸ The Federal Reserve (The Fed) The Fed is mandated to use monetary policy to achieve maximum employment and stable pricing. Their goal is to keep inflation at 2 percent. Inflation is a measure of the decline of purchasing power and is tracked by the US Bureau of Labor Statistics. They calculate the Consumer Price Index (CPI) by measuring the average change in price, over time, of a "basket" of selected goods and services. The CPI is based on 94,000 price quotes from 23,000 retail and service establishments, and 43,000 rental housing units. The inflation report for May was higher than projected. It was 8.6%. That is alarmingly high and explains why you cringe when pay for gas and groceries. The Fed can slow down inflation by making it more painful for people to spend money. They do this by raising the "Fed funds rate."
▸ The Fed Funds Rate
The Fed funds rate is the rate that banks charge each other for lending cash or excess reserves. It is also the rate that commercial banks lend to each other.
Significantly, the rate influences what banks charge their customers for loans. When banks are charged more, they pass that increase onto borrowers.
When the Fed got the news about May's 8.6% inflation, it hinted that they would raise the current fund rate by 75 basis points (100 basis points equals 1 % and 75 basis points is 0.75%). This was an increase from the anticipated 50 basis points.
The Fed acted as expected on June 15th and raised the funds rate to 1.75%. This was the largest rate hike since 1994.
When the Fed meets again in July, they will likely increase the rate another 75 basis points.
The Fed's longer term projections were also revealed.
The "terminal rate" is a mapping of projected rates over time on a "dot plot." It shows that the Fed will raise rates to 3.4% by the end of 2022 and it will peak at 3.8% in 2023.
Inflation is projected to drop from the current 8.6% to 5.2% by the end of the year.
▸ Recession The risk of the Fed's action is that they will slow the economy too much and we will end up in a recession. The National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic
activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." Is a recession inevitable? Over 60% of CEOs expect a recession over the next 12 to 18 months according to the Conference Board.
▸ Mortgage Rates
The Fed wants to see a cooling of the housing market and they have a powerful tool to do it.
In addition to increasing or decreasing the Fed's fund rate, the Fed can either sell assets from its $9 trillion balance sheet or buy assets.
After the COVID-19 pandemic, the Fed purchased over $4 trillion of US Treasurys and mortgage-backed securities (MBS).
US Treasurys are treasury bonds (mature in 20 or 30 years), treasury notes (mature in two and ten years), and treasury bills (mature in four weeks to one year).
Mortgage-backed securities (MBS) are mortgage loans that are bundled and sold in the bond market.
Between April 2020 and April 2022, the Fed's holding of MBS doubled from $1.35 trillion to $2.7 trillion. This represented an increase from 15% to 32% of the entire MBS market.
When the Fed sells its MBS, it pulls money from the economy. This is also likely to increase the costs of loan originations.
As mortgage rates climb, demand falls. After Memorial Day weekend, demand for mortgages hit a 22 year low.
NAR reported that home sales have fallen for six straight months.
▸ Housing Homebuilders are seeing a plummeting demand for new homes while supply costs are rising. Residential construction material is up 19% year-over-year. Another slowdown in homebuilding is going to cause a housing shortage after inflation is under control.
After the last financial crisis, home building dropped below historic norms for more than a decade. This resulted in the housing shortage that we have been experiencing. If new housing starts continue to fall, there will not be sufficient inventory for the tens of millions of millenials looking to buy a house over the next decade.
Thanks for reading! Please send me an email and let me know if you learned anything about the economy.
See you next week. Best, Rich Go to Crypto News for Realtors to read previous issues.