Fed Funds

Don’t Cut Rates

James Bailey2 Comments

The Federal Reserve will probably cut rates next week:

I can’t advise them on the complex politics of this, but based on the economics I think cutting would be a mistake. I see one good reason they want to cut: hiring is slow and apparently has been for a year. But that could be driven by falling labor supply rather than falling demand, and most other indicators suggest holding rates steady or even raising them.

Most importantly, inflation is currently well above their 2% target, 2.9% over the past year and a higher pace than that in August. Inflation expectations remain somewhat elevated. Real GDP growth was strong in Q2 and looks set to be strong in Q3 too, and NGDP growth is still well above trend.. The Conference Board’s measure of consumer confidence looks bad, but Michigan’s looks fine.

Financial conditions are loose, with stocks at all time highs and credit spreads low. Its only September and we’ve already seen more Initial Public Offerings than in any year since 2021 (when the last big bout of inflation kicked off):

Source: https://stockanalysis.com/ipos/statistics/

Crypto prices are back near all time highs and crypto is becoming more integrated into public stocks through bitcoin treasury companies and IPOs from Gemini and Figure.

The Taylor Rule provides a way of putting all this together into a concrete suggestion for interest rates. Some versions of the rule say rates are about on target, while others including my preferred Bernanke version suggest they should be closer to 6%. To me this is what the debate should be- do we keep rates steady or raise them? I see good arguments each way, but the case for a cut seems very weak.

I look forward to finding out in a year or two whether I or the FOMC is the crazy one here.

* The Usual Disclaimer, hopefully extra obvious in this case: These views are mine and I’m not speaking for any part of the Federal Reserve System.

A Continually Updated Bernanke-Taylor Rule

James Bailey4 Comments

Despite its many flaws*, I always like to check in on what the Taylor Rule suggests for the Fed. Its virtues are that it gives a definite precise answer, and that it has been agreed upon ahead of time by a variety of economists as giving a decent answer for what the Fed should do. Without something like the Taylor Rule, everyone tends to grasp for reasons that This Time Is Different. Academics seek novelty, so would rather come up with some new complex new theory of what to do instead of something undergrads have been taught for years. Finance types tend to push whatever would benefit them in the short term, which is typically rate cuts. Political types push whatever benefits their party; typically rate cuts if they are in power and hikes if not, though often those in power simply want to emphasize good economic news while those out of power emphasize the bad news.

The Taylor Rule can cut through all this by considering the same factors every time, regardless of whether it makes you look clever, helps your party, or helps your returns this quarter. So what is it saying now? It recommends a 6.05% Fed funds rate:

Fed Funds Rate Suggested by the Bernanke Version of the Taylor Rule
Source: My calculation using FRED data, continually updated here

I continue to use the Bernanke version of the Taylor Rule, which says that the Fed Funds rate should be equal to:

Core PCE + Output Gap + 0.5*(Core PCE – 2) +2

*What are the flaws of the Taylor Rule? It sees interest rates as the main instrument of monetary policy; it relies on the Output Gap, which can only really be guessed at; and it incorporates no measures of expectations. If I were coming up with my own rule I would probably replace the Output Gap with a labor market measure like unemployment, and add measures of money supply shifts and inflation expectations. Perhaps someday I will, but like everyone else I would naturally be tempted to overfit it to the concerns of the moment; I like that the Taylor Rule was developed at a time when Taylor had no idea what it might mean for, say, the 2024 election or the Q3 2024 returns of any particular hedge fund.

That said, people have now created enough different versions of the Taylor Rule that they can produce quite a range of answers, undermining one of its main virtues. The Atlanta Fed maintains a site that calculates 3 alternative versions of the rule, and makes it easy for you to create even more alternatives:

Two of their rules suggest that Fed Funds should currently be about 4%, implying a major cut at a time that the Bernanke version of the rule suggests a rate hike. On the other other hand, perhaps this variety is a virtue in that it accurately indicates that the current best path is not obvious; and the true signal comes in times like late 2021 when essentially every version of the rule is screaming that the Fed is way off target.

A Surprisingly Good Year for Homebuilders

James Bailey3 Comments

The Federal Reserve has been increasing interest rates at the fastest pace since the 1980’s, from near-zero rates in March of last year to over 5% today. This has led to rapid slowdowns in interest-rate sensitive sectors like housing, cars, and startups. Because most people finance their home buying, higher interest rates mean higher monthly payments for a house at a given price. Since many people were already buying houses near the highest monthly payment banks would allow them to, higher interest rates mean they need to buy cheaper houses or just stay out of the market and rent. This is especially true as the interest expense on mortgages has tripled in two years:

Source: Jeff Weniger

You’d think this would be bad news for homebuilders, and for most of 2022 markets agreed: homebuilder stocks fell 36% from the beginning of 2022 to September 2022 after the Fed started raising rates in March. But homebuilder stocks have recovered since September, with some major names like D.R. Horton and Lennar hitting all time highs. Why?

I bought homebuilder stocks in January but I have to say even I wasn’t expecting such a fast recovery (if I had, I would have bought a lot more). I was buying because they were cheap on a price to earnings basis and temporarily out of fashion; I love stocks that are priced like they’re in a secular decline to bankruptcy when its clear they are actually just having a bad cycle and will recover when it turns. But I thought I’d have to wait years for falling interest rates and a recovering housing market for this to happen. Instead these are up 20-100% in 6 months. Why?

The big thing I missed was that high interest rates have hit their competition harder, reducing supply as well as demand. Who is the competition for homebuilders? Existing homeowners. Homeowners with the “golden handcuffs” of a 3% mortgage who don’t want to move if it means switching to a 7% mortgage. I’m seeing this personally in Rhode Island- I’d kind of like a house with a bigger yard on a quieter street, but there are only 5 houses for sale in my whole school district. Between that and interest rates, we’re staying put. But for people who really need to move, new homes are making up a record proportion of the available inventory:

Source: Jeff Weniger

This situation seems likely to persist for at least months, and possibly years. The Fed paused its rate hikes yesterday for the first time since last March, but indicated that more hikes may lie ahead. I’m tempted to take the win and sell homebuilder stocks, but they still have price to earnings ratios under 10, and the “golden handcuffs” on their competition seem likely to stay on for at least another year.

Fed Dot Plot vs Markets

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After their last meeting in March, the Federal Open Market Committee released the summary of economic projections. Most of the variables they project are inherently difficult to predict: GDP, unemployment, inflation. But their forecasts of the Federal Funds rate should be pretty good, since they’re the ones that get to pick what it will be. The median FOMC member thinks the the Federal Funds rate will be just under 2% by the end of 2022.

I said in my last post that the Fed is under-reacting to inflation. Markets seem to agree, but they also think that the Fed will change. Kalshi runs prediction markets on what the Fed Funds rate will be, which they recently started to summarize using this nice curve:

So traders think that the Fed will raise rates faster than the Fed thinks they will, with rates getting to 2.5% by year end. Traders at the Chicago Mercantile Exchange see an even bigger change, with rates at 2.75% by year end, and 3.5% by July 2023 (the longest-term market they offer).

I lean toward the markets on this one; if they are wrong there is plenty of money to be made by betting so.