Upping the ante

Quick takes:

• Inflation upside surprises
• Tentative signs of hope
• Consumer sentiment actually up a bit
• Fed holds all the cards
• CRE will follow the economy

We don’t like to think of something as technical as economics in terms of gambling, but that analogy feels appropriate for this juncture. The data and likely responses to the data are effectively putting more at risk in an unusual economic environment without good historical precedent: a pandemic, significant increase in debt and money supply, and simultaneous war, mix after decades of globalization. Consequently, that leaves us without a good playbook for handling such an environment. This high-roller game holds huge implications for the future of the economy and all operating in it.

Inflation raising the stakes

Inflation data for June continued to show large headline increases. The consumer price index (CPI) increased 9.1% on a year-over-year basis, the highest in roughly four decades. The headline producer price index (PPI) increased 11.3% year over year. Meanwhile the core component of each continued to decelerate on a year-over-year basis. That highlights a trend we have discussed in recent periods: increasingly, non-economic factors like war and the ongoing pandemic are driving inflation higher. While economic factors like fiscal policy and the labor market continue to play some role in inflation, they comprise the supporting cast. Yet that could provide some hope. Not only is core inflation abating a bit, but inflation expectations are easing, prices of several goods appear to have rolled over, the supply chain is tentatively (but more consistently) showing signs of improvement, fiscal stimulus is fading and wage growth (at least by some measures) is decelerating. Of course, these are occurring during a period in which economic growth is already clearly slowing. 

Disconnect in Inflation Components

Will the Fed call?

Will the Fed call inflation’s bet? In the short run, yes. The Fed will almost certainly increase rates again this month, likely by 75 basis points (bps). It will likely continue to do so over the next quarter as it “front loads” its rate increases. But then what? As we have been saying, more important than how quickly they raise is where they stop – at what terminal rate? This seems less clear. Raising back to neutral seems prudent. But the Fed upped the terminal rate in its forecast beyond most anyone’s estimate of neutral at its last meeting. The futures market seems less certain that this will occur (as do we). 

The economy is slowing and higher rates will likely further contribute to that slowing. The standard playbook says that the Fed should raise rates to slow demand growth and tamp down inflation. But increasingly many are recognizing that playbook seems ill-suited for the current environment. And pushing too far increases the likelihood of causing collateral damage, even without accomplishing its aims. Is a world of full employment but moderate inflation (i.e., 4% to 5%) for a time unambiguously worse than a world with inflation closer to the Fed’s target but with millions of lost jobs, especially if the Fed still cannot influence the main factors driving inflation? We are asking rhetorically but the answer matters.

Consumers playing our hand

All of us in the economy are also playing in this game and are not merely spectating. While consumers clearly do not like inflation, their mood brightened a bit in July, likely with some prices like gasoline rolling over a bit. Retail sales in June surprised on the upside, even net of inflation, reinforcing our mantra of “watch what consumers do, not what they say.” Moreover, consumers are adjusting their spending patterns largely as we anticipated – away from goods and toward services, more in line with pre-pandemic norms. Interestingly, high prices for goods, which are more elastic than prices for services, are likely partially driving this shift. Private employment returned to pre-pandemic levels (governments are struggling to hire) at its fastest pace in more than three decades. Jobs abound for anyone who wants one and wages for blue collar workers are growing the fastest in the country, far faster than inflation, undermining the narrative that those workers are the most imperiled by higher prices. Therefore, consumers have much to lose from Fed tightening no matter how much they tell people conducting surveys they dislike inflation.

|  What we are watching this week  |

When the Fed raises rates, it goes after interest-rate-sensitive components of the economy. One of those key components, housing, will dominate the data slate this week. The homebuilders’ sentiment index should fall to its lowest level since the early stages of the pandemic. Housing starts and permits for June should show continued weaking after a significant spike in residential mortgage rates this year. Mortgage applications look set to slow again. Without saying so, the Fed would likely take all this as good news – slowing the housing market could presage price declines and future easing of inflation. But that remains to be seen.

|  What it means for CRE  |

Commercial real estate (CRE) has its chips on the table too. Generally, a healthy economy supports CRE and produces higher rents, lower vacancy rates and higher prices. A recession typically (though not always) produces the opposite. CRE will have to hope that the Fed can play its hand deftly. It seems excessive, but the short-run fate of CRE and the economy rests with the Fed. Over the longer term, outcomes across property types and markets will revert to a more complex mix of factors.

|  Thought of the week  |

According to the Official Airline Guide, June airline seat capacity in Las Vegas increased roughly 7% compared to the same month in 2019, the pre-pandemic benchmark.