“The average American’s standard of living must decline,” he said. “I don’t think you can escape that.” These were the words of Federal Reserve Chairman Paul Volcker when he testified before Congress in October 1979. Inflation was 13%. Volcker’s predecessors, Arthur Burns and William Miller, had failed to control prices. Stagflation gripped the United States. We were in an economic death spiral.
Volcker would then raise the Fed Funds Rate to 20% in 1981, sending the country into a deep recession. The 30-year rate reached 18% in October of that same year and unemployment surpassed 10% shortly thereafter. The average American’s standard of living had indeed declined.
But by 1986, inflation had been defeated (1.9%), mortgage rates fell to 10% and the Beastie Boys released ‘License to Ill’. At the time, I cared about any of these things. In 1988, unemployment was at a 5 handle and I was graduating from high school. The most painful economic period in modern American history was coming to an end. Volcker’s hard decision worked.
History is full of hard decisions.
In World War II, the British cracked Hitler’s Enigma machine and learned of the Luftwaffe bombings planned for Coventry, England. Churchill allowed the city’s demise to maintain his secret ascendancy. Deciphering the Enigma code was a crucial factor in the Allied victory over Germany in World War II.
Jacinda Ardern was Prime Minister of New Zealand when the pandemic began. In March 2020, she immediately locked down the entire country and issued a “Stay Home to Save Lives” directive. The economic and social setbacks were severe. Throughout the pandemic, New Zealand’s death rate from Covid was 0.086%, the lowest in the world. The death rate in the United States was four times higher.
A climax (pandemic), significant policy mistakes (temporary inflation) and irresponsible budget deficits have left the current Federal Reserve in a difficult position.
The Fed recently cut the fed funds rate for the third time this cycle while announcing that inflation would not reach the 2% target until 2027. The Dow Jones fell 1,100 points that day and the ten-year yield rose by the largest margin. on every Fed Day since 2013.
But first some economic data
I argue that our Bureau of Labor Statistics (BLS) reporting masks a much weaker picture of current economic conditions. Exhibit A: November QCEW report. While the monthly Nonfarm Payroll (NFP) issue gets a lot of attention when it comes to job creation, the QCEW is the gold standard behind the scenes. The Quarterly Census of Employment and Wages covers 95% of jobs with a sample size of 12.2 million firms. The NFP is a survey of only 629,000 companies with a response rate of 43%. The NFP has identified a surprisingly resilient labor market over the past two years. The chart below shows mortgage-backed securities supplemented with monthly nonfarm payroll figures through 2024. Note how MBS perform when NFP job creation is reported as robust. Of all the economic reports affecting mortgage rates, this is the big kahuna.
In November of this year, the much more robust and accurate QCEW effectively monitored job creation in the non-farm sector from the second quarter of 2023 through the same period in 2024. When the BLS reconciles these numbers in early 2025 and they are made official , then prepare for a ~1 million deduction from full-time jobs. Remember last August when the BLS cut 818,000 jobs from the first quarter of 2023 to the same period in ’24? That was not a one-off.
Chart courtesy of Mishtalk.com.
Exhibit B: Meanwhile, the BLS reports shelter inflation using extreme lag statistics and subjective surveys that inflate the overall inflation rate. Shelter/housing is the largest component of CPI. A bad quarterback on a good team can ruin the season. Shelter can have an influence on the CPI in the goods package like no other.
Replace this with a more data-driven method of aggregating rental prices, such as the Apartment List National Rent Index, and you’ll find inflation is already below 2%. Charts by Arkomina research.
So if the economic data is flawed at best or manipulated at worst, are Fed rate cuts inappropriate? If conditions are actually weaker than we think, shouldn’t the Fed be less restrictive?
No. Allow me to explain.
Incorrect thinking
Jerome Powell and his team try to win an unwinnable match. They’ve embraced the “soft landing” narrative, but have forgotten how to actually pilot. They act like politicians and play not to lose instead of doing what it takes to win.
This is their dilemma:
Option A:
• Keep the FFR high.
• Ensure that inflation is defeated.
• Bear the wrath of the president-elect and the nation.
• Risk of higher unemployment and unnecessary recession.
Option B:
• Lower the FFR and announce progress on inflation.
• Issue aggressive messages to avoid market exuberance.
• Attempt to return the economy to pre-pandemic conditions.
• There is a risk that inflation will flare up again and a painful cycle of interest rate hikes will restart.
The Fed has chosen option B. It’s the wrong choice.
To be clear: I am not Nostradamus. I’m the guy who invested his savings in Webvan when he was twenty-seven. But I understand the bond market and all I have to do is observe its reaction to see the wood.
What the bond market tells us
Below is a graph of the cumulative change in 10-year Treasury yields from the start of each Fed rate cutting cycle since 1989, courtesy of Bianco Research. The 10-year-old’s trajectory since September 18e is historic and a direct rejection of the Fed’s actions. In other words, the market isn’t buying what Jay and his team are selling.
The second graph represents the 2 and 5 year TIPS. Treasury Inflation-Protected Securities are designed to repay the principal and interest of a bond investment, but are adjusted to the CPI. This helps limit inflation risk due to devaluation of the investment, a common problem with bonds. The hashed vertical line is September 18ethe day the Fed started cutting the FFR. The market’s expectations for two- and five-year inflation have only increased since Jay and Team started cutting back. The market believes that Jerome Powell is at risk of becoming Arthur Burns. If they are right, it may take Volcker-like pain to correct this mistake.
Is the bond market always correct when it comes to inflation trends? No. Is it right this time? Maybe.
Does it matter whether the bond market is right or wrong? No.
We have proven that it is much easier for the Fed to stimulate our economy than to slow it down. Assuming the odds of an economic bullseye are minuscule, which side of this board should we be on?
The bond market’s rejection of the current Fed option leads to two of my favorite topics. Risk and math
The risk of option A is a recession and rising unemployment. For every 1% increase in unemployment, another 1.7 million people will lose their jobs. Job loss is cruel, and I don’t mean to make a comparison out of something devastating. If you are among those affected, your unemployment rate is 100%. But these are the tough requirements someone must accept if he or she wants to be chairman of the Fed. The downside of option A is that another 1.7, or 3.4, or 5.1 million Americans will lose their jobs. At 5.1 million, the unemployment rate would be above 7%. But inflation will be defeated.
The risk of option B is that inflation will flare up again. Here’s what the bond market is already starting to price and why long-term rates are rising. Inflation affects us all. We have 130 million households holding this
337 million Americans. A 2023 survey conducted by Payroll.org estimates that 78% of Americans live paycheck to paycheck. A similar survey from Forbes Advisor revealed a similar number: 70%. The same number of respondents have less than $2,000 in savings. A repeated increase in inflation for this group,
representing more than 90 million households means increased credit card usage, crippling debt, mortgage defaults, student loan defaults, auto repos, bankruptcies and the choice between groceries or rent.
The risk of option A is that Coventry is sacrificed to win the war.
The risk of option B is all of England.
This may be a difficult decision, but it isn’t. Even. Near.
Conclusion
The Fed must choose the lesser of two terrible things. The Fed needs to listen to the bond market and stop playing politician. Eliminate the “soft landing” flight plan and remember that there are passengers in the back who rely on their judgment. Not their legacy.
Leaders make tough decisions.
Back to Paul Volcker in 1979, sitting before Congress and concluding his testimony: “We face unpleasant economic conditions, and none of our choices are risk-free or pain-free. It’s time to tackle them.”
Mark Milam is the president and founder of Highland Mortgage.
This column does not necessarily reflect the opinion of HousingWire’s editorial staff and its owners.
To contact the editor responsible for this piece: [email protected].
