Today’s commentary
On Friday, I read a post on the New York City housing market that got me to thinking about how we view interest rates and their effect on credit markets. Traditionally, we view higher interest rates as a net tightening and slowing of the economy, while interest rate cuts are a loosening that should aid the economy. But is this really true? I say no. Tightening into frothy markets produces more froth. Some thoughts below
Here’s the article that sparked my interest in this: Manhattan Home Sales Rise to Year-End Record in Deal Rush. This is the part that I want to concentrate on:
Manhattan apartment sales surged in the fourth quarter, setting a record for year-end transactions, as the prospect of rising interest rates and prices pushed buyers to make deals before purchases became costlier.
[…]
Buyers are rushing into Manhattan’s market after a jump in mortgage rates since May, heightening competition for properties at a time when supply is dwindling. The inventory of homes for sale at the end of December fell 12 percent from a year earlier to 4,164, the lowest since Miller Samuel began tracking that data 14 years ago. Demand is pushing values higher, with the median price for a condo reaching a record.
“There’s a concern that homeownership will be more expensive and therefore the time to act apparently is now,” Jonathan Miller, president of New York-based Miller Samuel, said in an interview. “It’s a combination of rising mortgage rates and concern that prices are going to rise.”
[…]
Other reports issued today showed a frenzy of sales and record-setting prices for condos. Brown Harris and Halstead reported 2,664 completed deals in the fourth quarter, a 16 percent increase from 2012.
Their report showed condo prices set a record of $2.16 million on average, after rising 15 percent from a year earlier. The average price for units in new buildings climbed even higher to $2.89 million, Halstead and Brown Harris said.
Now, I know some of you are going to say ‘bubble’. But that’s not what I am focused on here. I wouldn’t say there is a bubble in New York real estate yet. But I do think the psychology shows that things are getting frothy as people are chasing homes.
What I want to concentrate on, however, is that people are chasing homes more because interest rates are rising. Do you see that? The article quotes Jonathan Miller saying “There’s a concern that homeownership will be more expensive and therefore the time to act apparently is now.” That’s not how interest rate hikes are supposed to work. So I want to explain what I think has happened and connect it to why the US economy has improved. This video of Warren Mosler on RT’s Boom Bust show gets at some of this. But I have more to add.
Explaining QE and tapering
Let’s start with QE, which is supposed to be a loosening of policy. Mosler said yesterday about QE what I said about QE when I defined what quantitative easing is in 2011.
“all [QE] does is drain the real economy of interest income by swapping an interest-bearing government liability for a non-interest bearing government liability. This decreases aggregate demand in the economy. So the real economy effects of QE are to slightly lower aggregate demand. This is offset by changing interest rate expectations, which alter private portfolio preferences, and lower risk premia, leading to credit growth, leverage and speculation, forces which should pump up the real economy.”
So QE has no positive real economy effects. It is merely a reduction in net interest income to the private sector because of the government bonds that the Fed takes out of circulation. The positive effect of QE is supposed to come from the signalling effect of policy accommodation. Supposedly this will both lower the term premium and have a residual effect on interest rate expectations, pushing back expectations of an interest rate hike. The end result will be lower interest rates net of changing inflation expectations. In addition, QE is a risk-on signal because it acts as a supplement to interest rate policy and forward guidance. It tells investors that the Fed will remain accommodative for longer. So investors can feel safe in dialling up the leverage and dialling up the risk while the Fed is engaging in QE because the Fed will need to stop QE before it can switch to a tightening bias and eventually increase rates.
This overview explains why the reaction to tapering was so violent in asset markets. The tapering signal was one of tightening i.e. that accommodation was being withdrawn and that QE infinity didn’t exist and will never exist. So those who had dialled up the leverage and risk, pulled in their bets and rebalanced their portfolios. The result was a rise of interest rates in the US and a sell-off of emerging market debt.
In short, QE only loosens policy if it induces more borrowing, more leverage, and more risk. The goal is to get people to lengthen their time horizons i.e. make longer-lived investments relatively more attractive, something that is beneficial to higher beta, higher duration asset classes and investments that rely on leverage.
Interest rates and the economy
All of my discussion on QE was in line with traditional economics i.e that higher rates are tightening and lower rates are loosening monetary policy. But this is not how the interest rate channel always works.
First, as I indicated at the outset of the QE discussion, the real economy effect of lowering interest rates is one of lowering interest income. This is completely offset by a reduction in interest payments. With QE, the private sector loses some interest income because some of the increased interest payments go to government and are lost to the private sector. Normally, from a real economy perspective, it is a wash. What that means is that for interest rate reductions to be stimulative, you need to add income from increased credit. This can only happen if the propensity to take on credit by creditworthy borrowers is relatively high. If I had to model this, I would have three variables, the change in private sector interest income from monetary policy changes, the change in private sector interest payments from monetary policy changes, and the increase in credit due to monetary policy changes.
If you recall, during the initial stages of the recovery, we were in a deleveraging period. And so despite the lower interest rates, the propensity to take on credit by creditworthy borrowers was low. That meant that QE was not very stimulative. But once asset prices recovered, things changed. In my post yesterday on easy money and fiscal withdrawal, I wrote that “[u]ntil 2013, the rise in asset prices was not enough to overcome the need for and psychology of deleveraging. This was particularly important regarding house prices, a leveraged asset that constitutes the bulk of most household’s net worth. The financial crisis put many households underwater on their housing investments. This led to an inability to refinance mortgages, a loss of mobility, mass defaults, and a general household deleveraging.
But in 2013, the US led the way in house price increases. That stopped deleveraging dead. Consumer credit is up, while debt service costs are at generation lows. So the US economy is improving now because the propensity to take on credit has increased as household balance sheets have recovered. Lower interest rates have created a credit accelerator whereas before they did not.
The asset-based economic model
The problem with what is happening in the US is that it is entirely dependent on asset prices and leverage as opposed to wage growth. If the goal was to use the credit accelerator as an economic jump start at the beginning of a credit cycle which then continued via wage growth, then this dynamic would be sustainable across business cycles. And this is traditionally how the US economic cycle performed during the halcyon days of the 1940s, 1950s and 1960s after World War 2. The result was a low level of household debt and reduced financial fragility. But starting in the 1970s, this dynamic changed and wage growth in real terms plunged before stabilizing during the stock market and housing bubbles.
“Real hourly earnings peaked at $20.30 per hour in January 1973, on the eve of the first oil shock. Over the next 22 years, it plummeted to $16.39. It now stands at $17.94, almost 12% lower than at its peak 35 years ago. In May 2008, hourly earnings growth y-o-y stood at -0.62%.”
And the poor wage dynamic continued after the financial crisis through at least 2011. I have not updated my charts but this one from a 2011 post gives the best graphical depiction:
“This chart was put together by David Rosenberg of Gluskin Sheff. It shows that wage growth in the U.S. is not keeping pace with inflation. For the statistical recovery to continue sustainably, we will need to either see this trend reversed. Alternatively we could see an increase in aggregate debt levels or a disproportionate increase in consumption from higher net-worth consumers as a bridge to longer-term growth. Over the short-term, fiscal headwinds will make the wage growth picture worse. The question is about the medium-to-longer term. Without sustained real wage growth for the middle class, upper-income consumption and debt accumulation are a bridge to nowhere.”
In the face of this poor wage growth, US households have levered up, something that the secular decrease in interest rates since the early 1980s has made much easier. And that’s why we are in the predicament we are in now. Interest rates cannot be lowered any more and wage growth is still weak. That means that an increase in household leverage could be met with a particularly nasty deleveraging in the next down cycle if interest rates have no room to move down to reduce debtors’ interest payments.
Frothy markets and interest rates
And that leads me to how interest rates work in the asset-based economy at cyclical peaks. When economic growth is predicated on asset price increases, it leads to frothy markets and bubbles in which the psychology of rising prices take over. In normal circumstances, prices rise and the rise in prices is only marginally important as an influence on future price direction. But when prices rise for a long time and by a lot, previous price movements become highly correlated to subsequent price movements. This is the essential property of a bubble and crash – the entire lack of randomness of price correlation over time.
When central banks tighten into a frothy asset market psychology, the effect is the opposite of what traditional economics would dictate. Instead of seeing interest rate increases as something which restricts the propensity to take on credit, frothy market participants become alarmed that interest rates are going up before they have a chance to leverage into the rising market. Higher interest rates act as an accelerator of frothy markets because the anticipation of future price increases dominates the increased carrying cost of borrowing at higher rates creating rate lock-in panic. That’s what you are witnessing in New York City as told by the housing brokers there.
This is really dangerous stuff and it has serious implications for policy. To the degree you believe that central banks have an asymmetric policy response that favours froth and promotes bubbles by delaying tightening, you should anticipate an eventual tightening will actually accelerate frothy conditions. That means that a central bank that tightens when it is behind the curve is actually promoting an asset bubble unless it tightens quickly enough to overcome the anticipation of higher prices that produces panic lock-in credit accelerators. If you look at Greenspan’s quarter-point rate rise regime during the US bubbles, his policy was a recipe for disaster. The increase in rates accelerated the desire to lock in rates. It precipitated rate lock-in and boosted credit rather than reducing it.
This is the dynamic we see with tapering as well. The Wall Street Journal made this plain last month:
“Bank executives say corporations have held off on taking out loans because they have not seen any near-term risk that interest rates will rise. But tapering by the Fed, which would lead to rising rates, could be the catalyst businesses need take out money to invest in their operations, bank executives said Tuesday.”
“There’s a lot of commerce that’s sort of sitting on the sidelines, waiting to get in the game,” William Rogers Jr., chairman and chief executive officer of Atlanta-based SunTrust Banks Inc. (STI), said at an investor conference in New York. He added that there hasn’t been a “particular impetus,” such as an impending tax change, for businesses to borrow because rates have remained low.
“Tapering might change that,” he said, serving as a “signal that it’s time to” borrow.
So, with the Fed on easy street and not moving aggressively, we should anticipate more credit growth and higher GDP growth as a result. This is why I am not bearish on the US economy despite the lack of wage growth. We are now in the froth period of an asset-based economic cycle and the changes are now all about asset prices and credit growth. The unintended consequences will come later when the cycle finally turns down.