Viewpoints: October 2023

Monetary policy influences nominal spending in the economy. In the third quarter, nominal GDP grew 8.6% annualized. So far, in 2023, nominal GDP is running at an annualized pace of 6%. That follows a 10.6% gain in 2021 and a 9.1% gain in 2022. The three-year increase, 2021 to 2023, represents the fastest three-year advance in nominal GDP since the mid-1980s.

The economy's nominal growth performance has two critical messages/implications for policymakers and analysts/portfolio managers regarding Fed policy and market rates.

First, except for the non-economic slowdown following the pandemic, it has taken a Fed funds rate equal to or above the growth in nominal GDP to engineer a sustained growth slowdown/recession. The target on the Fed Funds rate is still 75 basis points below the growth in nominal GDP.

Second, many analysts and portfolio managers still expect a return soon to the interest rate pattern of 2008 to 2020. Yet, that interest rate pattern was abnormal, as was the nominal growth path in the economy. Only once did nominal GDP grow more than 5% during those twelve years, which occurred in 2018. The average gain was about 4%.

The interest rate pattern more applicable to the economy's current growth performance and policymakers' intent to lower inflation is from the mid-1980s to the mid-1990s. At the start of that period, the Fed funds rate, as did the 10-year Treasury yield, exceeded the Nominal GDP growth. Then, in the later part, nominal growth and nominal rates were more in line with one another.

The longer it takes the Fed to adjust policy to the current growth dynamics, the longer it will be before the economy slows and market rates fall.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in September were again soft, and the results were very similar to August’s. 19 states show declines from August, with West Virginia down nearly 1 percent. The largest increase was .65 percent in Maryland.in the rate of growth. Over the 3 months ending in September 10 states had declines, with West Virginia’s -2.2 percent the largest, while Montana was also down more than 1 percent. Maryland had the largest gain, at 2.25 percent. The results are less lackluster at the 12-month horizon, with Maryland up 7.8 percent and Massachusetts and Vermont both up more than 6 percent.. 3 states had increases of less than 1 percent, with New Jersey up a mere .20 percent.

The independently estimated national figures of growth over the last 3 months (.7 percent) and 12 months (3.1 percent) both look to be roughly in line with what the state figures suggest.

State labor markets were soft-to-mixed in September. Only 6 states saw statistically significant increases in payroll, though none reported a statistically significance drop. Texas gained 61,400 jobs and South Dakota reported a .9 percent increase. September was the third straight month in which the sum of state job changes fell short of the national figure; the sum of the differences since June is around 150,000.

A full 16 states had statistically significant increases in unemployment from August to September, with a .3 percentage point increase in Illinois. Once again, Nevada continues to have the highest rate of any state in the nation, at 5.4 percent. Nevada and DC had unemployment rates at least one point higher than the national average of 3.8 percent. (California is the only other state with a rate statistically higher than the nation. Alabama, Florida, Hawaii, Kansas, Maine, Maryland, Massachusetts, Montana, Nebraska, New Hampshire, North Dakota, Rhode Island, Utah, Vermont, and Virginia, were all at least a point lower, with Maryland at 1.6 percent.

Puerto Rico’s unemployment rate moved down to 6.0 percent. The island added 2,000 jobs, and the private-sector total set a new all-time high.

Critics argue that the current inflation rate is much lower than the published rate. That is true; based on the current methodology, "real-time" consumer inflation is less than the published rate. Thirty-five percent of the prices used to estimate the consumer price index are not for the current month but reflect the prices over several months, according to the Bureau of Labor Statistics. Most of that involves the owner's rent index. Because rents change infrequently, the Bureau of Labor Statistics measures these service prices over six-month spans.

The owner's rent index is the brainchild of government statisticians and academia, supported by politicians who want a lower, less volatile price index. Yet, the owner's rent index has two "major" problems.

First, it is not a current price. Rent changes, up or down, would not be captured in the CPI until six months after they occurred. So, given its massive weight in the index, owners' rent would result in reported inflation running below current inflation at the beginning of the rent price cycle and overstate it at the end.

Second, it is not an actual price. The owner's rent index is supposed to measure or capture inflation experienced by people who own a house. But no homeowner pays that price. Economists and policymakers often talk about demand destruction from higher inflation, but there is no demand destruction here since no one pays the price.

A "real-time" and more accurate measure of inflation would require a shift back to the inflation methodology pre-1983. That would include house prices and mortgage rates, creating a real-time, more volatile, and higher published inflation rate. So pick your poison---a flawed index or a higher volatile index? Complaints about the current CPI are frequent, but they would only get louder if a shift to a real-time measure of inflation occurred.

Policymakers are learning in "real-time" the staying stimulative power of the Fed's quantitative securities purchases (QSP) and the scale of official interest rates required to neutralize its effects. How else can anyone explain 800,000 new jobs (60,000 in the interest-sensitive construction industry) created over the July-to-September period and estimated GDP growth of nearly 5% for Q3 after over 500 basis points in official rate hikes in the past 18 months?

Former Fed Chair Ben Bernanke, the mastermind behind this new policy tool, argues that QSP helps to lower long-term yields, and the effects are long-lasting. How long? No one knows, but one way to track the QSP effect is by looking at the spread between long-term yields and Fed funds.

The Fed has been raising the Fed funds rates since March 2022. For half of those 18 months, the yield of the 10-year Treasury has run well below the Fed funds rate and still is well below. During every Fed tightening cycle of the past 35 years, the 10-year Treasury yield ran equal to or slightly above the Fed funds rate, especially when the economy was strong, and the Fed still was leaning towards more rate hikes.

Most of the focus of QSP is its direct impact on the Treasury yields. However, it also involves direct cash transfer (liquidity) into the financial markets and the economy as the Fed buys securities from investors. The Fed added $5 trillion to QSP over two years, which boosted asset prices and directly and indirectly consumer investment and spending behavior.

Mr. Bernanke also argues that for QSP to be effective, the economy's nominal "neutral interest rate" (observed after the fact) must be between 2% and 3%. Suppose the "neutral interest rate" is twice that, or 5% to 6%, close to the current target on fed funds, and is rising as is the case nowadays.

Does the stimulative power of QSP increase as the economy's nominal "neutral interest rate" increases, especially when the scale of QSP is still enormous? Mr. Bernanke never contemplated this scenario or how to exit QSP when policymakers needed to shift the stance of monetary policy to the restrictive side.

We are in uncharted territory because never before has there been a period of a rise in the economy's nominal "neutral interest rate" and enormous QSP. At the end of September 2023, the Fed's security holdings stood at $7.44 trillion, roughly $1 trillion below its peak, but still stood nearly $ 4 trillion above the level when the Fed started its latest QSP program in 2020.

Does the stimulative power of $4 trillion of QSP outweigh the adverse effects of an estimated $100 billion increase in household net interest costs? The economy's growth performance says it does, but financial conditions models say the opposite. Why? Financial conditions models omit QSP.