At last week’s FOMC meeting, Fed officials implied they may raise interest rates as soon as 2023, perhaps a year earlier than anticipated. We were not surprised. And during a post-meeting news conference, Fed Chair Jerome Powell said that the central bank was starting talks about when to pare down its monthly $120 billion of purchases of government bonds and securities put in place last year to support the recovery. Again, we were not surprised. But in Tuesday’s appearance before Congress, Powell reaffirmed the central bank’s commitment to encourage a “broad and inclusive recovery” in the job market and indicated the Fed would avoid raising interest rates too early based only on the fear of future inflation. Subsequent trading in inflation-protected and other securities implied investors are betting the Fed will change its policies faster than projected and we would agree. And in our view, Powell’s commitment to a “broad and inclusive recovery” was simply pandering to a Democratic majority in Congress. We assume Powell understands the limits of Fed policy and what it can and cannot achieve. The Fed’s tools are both broad and blunt. It is unable to target areas of the economy to support job growth. It can only increase liquidity in the system and hope that this will lift all boats. It has not. It is the role of the administration and Congress, not the Fed, to target areas of the economy.
Only Congress can target economic areas of greatest need by encouraging business investment, by lowering the restrictions and taxes on small businesses and inspiring job growth. Unfortunately, they are not doing this. We are not surprised. However, related to President Biden’s $1.9 trillion American Rescue plan, on July 15, the IRS will begin sending out monthly payments to around 36 million families as part of an expanded child tax credit program. Families will get an $1,800 supplemental child tax credit divided into six payments that will be sent out through December. If you qualify, you will get $300 per month for each child under the age of six and $250 per month for every child between the ages of six and 17. To qualify you must be a single taxpayer with an income up to $75,000, a head of a household with an income up to $112,500, or a married couple filing jointly, a qualified widow, or widower, with an income of up to $150,000. Families with higher incomes will receive $50 less per $1,000 earned. Payments will be phased out for people who make roughly $20,000 more than the relevant threshold. However, we were surprised to read that a family of four making less than $150,000 could see more than $14,000 in pandemic relief this year from the expanded child tax credit and $1,400 stimulus checks to both adults and children. This means some households could receive government checks totaling as much as $16,800! For a family making $149,000 a year this is a potential 11.3% increase in income. For some families, it could actually double annual household income this year. It is significant for a large number of families in the US.
We applaud the effort to assist the millions of families with children that that have fallen below the poverty line as a result of last year’s government shutdowns. Nevertheless, this is a stop gap program. Households could be permanently lifted out of poverty if they had more opportunities for better paying jobs and if they did, they could also make plans and have hope for a better future. This could be accomplished by putting government money into job training, childcare, tax exempt small business loans, creating public/private opportunity zones in areas blighted by the pandemic, and removing restrictions and lowering taxes on new small business owners. This type of constructive fiscal policy would have a positive long-term impact on household financial and mental health. It is the role of our elected officials. It is not the role of the Federal Reserve. But it is not happening. We are not surprised.
Fed Policy Is Pivotal
There are a number of reasons why we believe the Fed will be forced to change its policy this year. And as seen by the market’s reaction after last week’s FOMC meeting, a change could have an immediate and negative impact on the securities markets. Since the end of 2019, or just prior to the pandemic, the Federal Reserve’s balance sheet has grown by $3.85 trillion, the equivalent of 17% of nominal GDP. In short, an amazing amount of liquidity has been pumped into the banking system and the pumping has not ended. The Fed plans to continue its $120 billion in asset purchases each month. See page 3. However, in our view, quantitative easing is apt to be the first change in monetary policy and it will not surprise us if the Fed slows or ends its asset purchases in the second half of the year.
Yet while the Fed has been stimulating the economy with a soaring balance sheet and low interest rates, households have been hoarding cash. Since the end of 2019 through to May 3, demand deposits at commercial banks have increased a stunning $2.22 trillion to $4.0 trillion. See page 4. This cash hoarding could become a liquidity trap for the Fed, since it means the Fed’s actions are not having the positive impact on the economy it had intended. More stimuli could simply become pushing on a string, i.e., a true liquidity trap, and investors will lose faith in the Fed. In our view, this would be due to poor fiscal policy that provides households with ever more cash but does not emphasize future job growth. Households may simply be boosting savings for the rainy day they see ahead. This could explain why both the small business and consumer confidence surveys recently saw significant declines in “future expectations” even though current conditions remained stable.
With the fed funds rate at 0.1% and May’s inflation as measured by the CPI at 5%, the real fed funds rate is negative 4.9%, or its lowest level in over 70 years. This is worrisome since it is an extremely dovish policy for a non-recessionary, and expanding environment. According to the Fed, the economy is recovering and if so, monetary policy should change. See page 5. Plus, the economic backdrop is not good for the Fed or households. Core CPI and PPI are up 3.8% YOY and 2.9%, respectively. The PCE index is up 3.6% YOY. Headline CPI and PPI are up 5% and 8.7%, respectively. Prices are rising in most areas of the economy, and we doubt this is transient inflation. In our view, a small change by the Fed now could prevent the need for huge interest rate hikes in the future. Moreover, inflation is the equivalent of a tax on consumers, and this too is adding to the anxiety households have about their financial future. See page 6.
Housing and autos were the center of the economic recovery in 2020. This year auto sales remain strong, and prices of old and new cars are rising. Housing, on the other hand, may be about to plateau for a variety of reasons. May’s median existing home price rose to $350,300, a 24% YOY increase and the biggest gain on record since 1999. Yet, mortgage applications fell 17% YOY and existing home sales fell to 5.8 million units, down 0.9% month-over-month, but still up 45% YOY. Rising prices and falling sales could be due to a lack of supply since months of supply remained low at 2.5. But we believe first home buyers are being priced out of the market since house prices are rising faster than incomes. This could be more than a short-term situation. Remember: there were 7.6 million fewer people employed in May than in February 2020. Little has changed in the market’s technical condition. The 25-day up/down volume oscillator is in neutral and falling – a sign of weakening demand for equities. The NYSE advance decline line made a new high June 11. The Nasdaq Composite index eked out a new high this week and this index bears watching. The IXIC has been trading in a range of 12,995 to 14,200 most of this year. If this week’s move to 14,253 is indeed a breakout it could propel equities higher. If it becomes another failed rally attempt, it may be a short-term warning sign for investors. Stay alert.