The dynamics of the US economy and its financial markets can often be quite perplexing. What seems straightforward can defy expectations, while something seemingly minor can unexpectedly become a significant focal point.
For instance, gross domestic product (GDP) may rise despite alarming economic indicators, and a prolonged bear market rally might appear to signal the dawn of a new bull market.
Additionally, when policymakers engage in substantial market manipulation, the distortions and misleading signals can become even more confusing. Prices may stray from rationality for extended periods.
The question arises: can Fed Chair Jay Powell successfully guide us to a soft economic landing?
Marriott’s CFO, Leeny Oberg, seems optimistic. During the latest earnings call, she stated, “it now seems more likely that the US economy could have a soft landing.”
“Recently, we’ve witnessed strongly positive employment numbers and rising expectations for GDP growth. Additionally, inflation appears to be subsiding, which helps foster a sense of optimism about a potential soft landing without a significant downturn.”
At the Economic Prism, we remain skeptical. Even if we do witness such a scenario, we might not readily believe it.
Assuming that a situation is set in stone before it materializes can lead to disappointments. Remember President George W. Bush’s “Mission Accomplished” speech delivered just weeks after the Iraq invasion in 2003? The mission was far from completed, and the true outcomes remain contentious nearly two decades later. What was achieved, really?
Shortsighted Thinking
The anticipated financial turmoil and economic downturn may be far more severe than many are currently predicting. In fact, this emerging enthusiasm for a soft economic landing may ultimately appear quite misguided. Reconciling a staggering $5 trillion debt—accumulated on top of a 50-year borrowing spree—is no walk in the park.
Such reconciliation is inevitable, albeit will unfold in due time. Here’s the reasoning:
From 2008 to 2022, the zero interest rate policy (ZIRP)—with a brief pause in 2017-18—failed to reflect its effects immediately in the Consumer Price Index (CPI). However, its impact was evident in asset prices across stocks, bonds, and real estate. The delayed effects of ZIRP took time to show up in CPI inflation.
As expected, the Fed’s ZIRP eventually culminated in a 40-year high in consumer price inflation. To rectify its earlier policies, the Fed began rate hikes starting in March 2022, raising rates from near-zero to the current range of 5.25 to 5.5 percent.
Despite the collapse of Silicon Valley Bank and other financial institutions such as First Republic, these rate increases have yet to lead to a significant financial crisis. This has been interpreted by soft landing proponents as validation of their views.
However, we believe such optimism is shortsighted. Just as the effects of ZIRP took years to manifest in consumer prices, the repercussions of the Fed’s rate hikes will also take time to emerge. The results will likely be unpredictable and erratic.
As borrowing costs rise, various sectors of the economy will respond differently, sometimes in surprising ways.
Low-Mortgage Handcuffs
Consider the residential real estate market. Typically sensitive to escalating interest rates, this market has witnessed 30-year fixed-rate mortgages soar from 2.65 percent to 7 percent in the past two years. Meanwhile, home prices remain at all-time highs, making them increasingly unaffordable.
First-time homebuyers hoping to achieve the American dream now need to earn 13 percent more than last year just to afford a starter home. How many potential buyers have seen a 13 percent increase in their earnings?
It’s unlikely many have.
Given the unaffordability of homes in many regions, what is delaying an anticipated housing market crash?
The response lies in the Fed’s manipulation and attempts to manage the economy by controlling credit costs.
Smart homeowners seized the opportunity in 2021 to refinance at fixed rates below 3 percent. Now, many find it challenging to sell and relocate.
Essentially, homeowners are trapped by low mortgage rates—akin to being in handcuffs. They feel stuck, unable to move, and are dissuaded from selling their homes for fear of losing their favorable mortgage rates.
This phenomenon has led to a significant decline in the availability of starter homes. According to Redfin, new listings for starter homes in June plummeted by 23 percent compared to last year, resulting in a 17 percent drop in the sales of previously owned houses during the same timeframe.
Can you see the unfolding situation?
How the Fed Retarded the Residential Real Estate Market
Although homes are priced out of reach for many, values remain elevated due to severely constrained supply. In essence, the Fed has hindered the residential real estate market. Only central planners could achieve such a reversal.
This dynamic presents several implications. Firstly, an overpriced housing market struggles to clear, resulting in a painfully slow crash.
The future trajectory of this situation remains uncertain. What will transpire when the economy heads into a recession, driving unemployment rates higher?
Will a significant number of unemployed homeowners be compelled to sell their properties under pressure? Will they realize that renting a subpar apartment costs more than their current mortgage?
These are the unwelcome choices individuals may face when central planning distorts market functioning. However, the issues do not end there…
A thriving, innovative economy thrives on individuals seeking opportunities. The most talented are drawn to environments where their skills are maximally rewarded, leading to progress.
Such momentum drives the creation of new technologies, products, jobs, and methods, ultimately contributing to economic growth and wealth generation.
But what happens when people, hindered by low mortgage rates, choose to remain in place?
Unfortunately, the vibrant economy that could have been fails to materialize. The productive activities and wealth generation that ought to unfold are curtailed before they can even begin.
GDP growth stagnates; living standards plateau.
Most importantly, the buzz of productive energy dissipates, replaced by a sense of apathy.
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Sincerely,
MN Gordon
for Economic Prism
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