Essential Economics

 — Mark Frears

Perspective

Each of us has our own view of life, based on what we experience day-to-day. On my first visit to Seattle, I had been on the train since Chicago and had never set foot in the city before. My view was kind of intimidating, all the unknowns. When I arrive in Seattle now, it is with familiarity and excitement. I know where I am going and how to get there. The markets experienced a change in perspective last week, without any forewarning!

Housing

We all must live somewhere, whether we own a home, rent an apartment, or live in our parent’s basement. If you own a home, you most likely have a nice low interest rate on your mortgage. If you rent, you have experienced rising costs, even before the impact of supply chain disruption. There are too much demand and too few living spaces available. This will take some time to balance out, so these living costs will stay higher. 

Last week we had two opposing housing releases. Existing home sales came in lower than expected. With rising rates, mortgages are not as attractive, but we are coming into the time of the year when many relocate. Later in the week, new home sales reversed April’s 12% decline with a 10.7% increase. This was only a bounce-back, not a new increasing trend.

Confidence

On Friday, we had the latest University of Michigan (better school up in East Lansing) Consumer Sentiment release. This survey of consumer attitudes/views dates to 1946 and has become a benchmark for inflation expectations. The overall metric dropped to a 40-year low; let us dig into some of the details.

There are two specific questions on future expectations. One, how much do you expect prices to go up in the next five to 10 years? This month they see a 3.1% increase, down from an earlier reading of 3.3%. Two, how much will prices increase over the next 12 months? That expectation dropped from 5.4% to 5.3%. 

As you can see, these are both at sustained elevated levels. Given the continued attention on prices at the pump and in the grocery store, demand has not slowed enough for us to see a lower price trend. 

Popular inflation measure

Last week the Consumer Price Index (CPI) was released with much fanfare just down slightly from recent highs. The three biggest components are food, energy and shelter, making up 54% of the index. The category of “services less energy services” makes up 57% of CPI and has risen 5.2% over the past 12 months. The next largest group is “commodities less food and energy commodities,” which makes up 21.4% and is up 8.5% over the past 12 months. Put this in perspective since the two smallest categories involve energy. These two categories make up 3.4% of CPI, yet they are up 50.3% and 16.2% this year! So, your pain at the pump really does not flow through to what we see in CPI, making it worse than it appears. 

What do you want?

As you recall, the Federal Open Market Committee’s actions (FOMC) regarding short-term interest rates are very closely watched by Wall Street. Right now, their focus is on quelching inflation and their tool to do that is by increasing rates enough to slow down the economy and reduce demand. How far and how much are very much in people’s minds. 

The “r-word” has been bantered about in the media and in questions to the FOMC members. Will they be able to slow the economy enough to have a “soft landing” and keep prices from soaring? Or will they push rates so high that we plunge into recession?

Last week, sometime between Wednesday and Thursday, market sentiment changed. Huge. The three-year U.S. Treasury note dropped 35 basis points (bp). The focus moved past the inflation concerns and assuming the FOMC would have to start cutting rates before mid-year 2023. 

This market sentiment shift primarily impacts interest rates, and by association USD levels. What this does not affect is the current impact of inflationary prices. It still costs more to live right now and that will not change quickly. While the economy is slowing, some due to expected rate increases, and some due to consumers starting to pull back on purchases, it will take time for the slower demand to flow through to prices.