The writer is a lawyer by training who deals with and is involved in technology. Manages a cryptocurrency investment fund, and lives in Silicon Valley. Author of the book “A Brief History of Money” and the KanAmerica.Com podcast recorder
At the end of August, the chairman of the Federal Reserve, Jerome Powell, disappointed the investor crowd when he announced in a speech in Jackson Hill that the Fed was resolute in its promises to change the 12-year expansionary monetary policy. This determination may have been surprising, but it is not incomprehensible.
The first wave of price increases has already spread throughout America. From the price of a cup of coffee to housing prices, it seems that things are out of control. The interest rate increases of the last few months will also make the cost of credit more expensive for businesses and consumers, and in order to continue to maintain the level of spending they have become accustomed to, everyone is now trying to find additional sources, through wage increases or price increases. It is also clear to the Fed that if it does not put a “concrete ceiling” over the attempts to roll over the overheads and wages, the inflationary spiral will continue to grow.
On the employment front, which is the only one that really worries the Fed, things are far from slowing down. In the report of the Government Bureau of Statistics, published at the end of August, it was reported that as of the last day of July there were 11.2 million unfilled jobs in the American economy. The employment report for the month of August shows that the official unemployment rate is about 3.7%, far below the accepted 5% line. The data show that wages also continue to climb. The hopes of the markets and investors for a quick change of direction by the Fed therefore seem like a pessimistic dream.
Is Powell the new Volcker?
At the end of the seventies of the last century, inflation in the US was on the rise. In 1979, the Federal Reserve made a decision to steadily increase interest rates until the money supply was significantly and noticeably reduced.
With the increase in interest rates, they began to press against each other. Politicians attacked and demanded to stop the immigration, the protestors began to demonstrate in front of the Federal Reserve building, and an armed man entered the building in order to reach the governors’ meeting. Things got to the point that Mirava was attached to Fed Chairman Paul Volcker, for fear of harming him. But the Fed continued with the feeling that it had no choice.
In his book released shortly before his death at the end of 2019, Volker said: “We could not withdraw from our new policy of reducing the money supply…we had no other option. Did we know then how high the interest rate would reach so that we could say we succeeded? No.” Finally the interest rate reached about 20% and the economy entered the most severe recession since the 1930s. Then inflation broke.
The real estate market began to absorb the increases
In the meantime, the interest rate on mortgages continues to climb, and at the beginning of the month it crossed the 7% percent line. This is compared to about 2.6% just a year ago. This sharp and rapid increase has boosted repayments on new mortgages. For example, the monthly repayment on a house purchased at a price of 650 thousand dollars and financed with 80% of a mortgage, a year ago, including taxes and insurance, was about 2,365 dollars. Now with 7% interest, the monthly repayment has jumped to $3,743.
The increase in the cost of financing not only drives investors and new buyers out of the market, but also dramatically affects the housing developers. For example, the monthly repayment of a household that purchased a house for $400,000 a few years ago with a 20% cash payment and 80% mortgage with an interest rate of 3.5%, was until recently $1,720. Now that the price of the house has risen to $540,000, and she wants to improve housing and buy a house that costs $750,000 with an 80% mortgage and with an interest rate of 7%, the monthly repayment has jumped to about $4,250 – two and a half times. Such a change means that the monthly return of a household that earns $100,000 gross per year (= about a third above the median salary) jumped from 21% of the gross income to 51% or about 60% of the net income – far beyond the 36% threshold allowed for credit , and the logical one for maintaining the household.
Paul Volcker, Chairman of the Fed between 1979-1987 / Photo: Associated Press, Seth Wenig
Given such numbers, it is no wonder that the rating company Moody’s estimated last month that house prices in the 183 largest markets, out of the 413 markets in America, are overpriced by 25% or more. Some of them, which were particularly popular and whose prices have risen sharply in the last two years, were overpriced much higher. Boise, Idaho, for example, was overpriced by 72%; Prices in Austin, Texas and Charleston, North Carolina are selling for 61% above their true value, according to the report.
Not a zabang event and we’re done
In his speech at the conference in Jackson Hole, Fed Chairman Powell mentioned that Paul Volcker’s fight against inflation was not a fluke and we finished: “Volcker’s success in the early 1980s in lowering inflation was after repeated failures to do so for 15 years. A long period of very strict monetary policy was ultimately required to stop the high inflation and start the process of lowering it to the low and stable level that was the norm until last year. Our goal is to prevent a similar process by acting decisively now.”
The Fed thus proved that in the meantime it knows how to talk like Volcker. Now it remains to be seen how well he knows how to drive like him.
After a decade and a half of monetary wizardry, zero interest rates and trillions of dollars in quantitative easing, the markets refuse to believe that the “Greenspan put option”, which gives investors the right to sell a stock at a predetermined price, will disappear and be replaced by Volcker’s determination.
Investors seem to find it difficult to believe that the Fed, which collapsed easily and quickly in the fall of 2018 when the markets reacted with a shock to the promises of the chairman of the Fed at the time, Janet Yellen, to normalize the interest rate, will stick to his talk of reaching a basic interest rate of 4% in 2023, and will also reduce its balance sheet by trillions. These actions may send the bond market to declines the likes of which have not been experienced in forty years, the market and stocks to declines in the style of 2008 and the entire economy to a recession.
So far the Fed has been fighting inflation with no visible casualties. Employment is still at a peak, the S&P500 index is still trading within a range of about 10% of its price a year ago, and the yield on the 10-year government bonds is still in the region of the yield it was in 2018, far below the inflation rate. Even house prices have not started to react in a real way to the sharp rise in mortgage interest rates. Furthermore, even wages continued to rise. Talk of a recession is therefore still talk at this stage, but it will not curb inflation. Larry Summers, former Treasury Secretary in the Clinton cabinet, recently said in a speech in London that “to stop the Inflation we will need two years of unemployment of 7.5% or five years of unemployment of 6% or one year of unemployment of 10%.”
Huge deposits are waiting on the lines
The water has stopped flowing, but the pool is already full to the brim. As of the beginning of September, the commercial banks’ deposits with the Federal Reserve (“reverse repo”) stood at over 2 trillion dollars, an unprecedented amount of money that they prefer to deposit in the central bank instead of lending it. In addition, according to a report by the Federal Reserve from June 2022, “After the corona virus, there was a rapid increase in the amount of deposits in the banking system. The total deposits in commercial banks in the US increased by 35% since the end of 2019 and stood at 18 trillion at the end of 2021.
Declaring war on inflation, modest increases in interest rates and slight decreases in the stock market will not really do the job, when sums of such magnitudes are waiting on the lines for the time to return to the economy. The key to lowering inflation, no less than the interest rate, is a vigorous reduction in the money supply in the economy. Since 2008, the Fed’s balance sheet has grown by more than 8 trillion dollars, to almost 9 trillion of government bonds (about two-thirds) and mortgage-backed bonds (about a third), which the Fed purchased to finance the government deficit and to make sure that their price, the interest rate, will remain low Since the peak in April, the Fed has cut a negligible amount of about 140 billion in this balance sheet. According to the Fed’s plans as published in May of this year, the rate of reduction in the balance sheet will increase from next month to 105 billion per month, with 60 billion in government bonds and 35 billion in mortgage-backed bonds. A reduction that will be achieved mainly by ceasing the purchase of new bonds against those maturing.
Although the government reduced the deficit a little, this year’s budget should end with a large deficit and add another trillion dollars to the debt. In addition, the government will need funds to recycle the old debt due for repayment. Without purchases by the Fed, this government demand for money will cause the yield on government bonds to climb. Along with it, the interest rate in the entire economy will climb, of the prime interest rate, corporate bonds and mortgages. But not only the federal government will need trillions of credit to finance and refinance its debts, the private market also has such debts.
From the second half of this year until the end of next year, 350 billion dollars of investment-grade corporate bonds are expected to mature; another 300 billion dollars are expected to mature in 2024; in the non-investment bond market -grade) are expected to reach maturity of $225 billion by the end of 2023, and more bonds amounting to $306 billion in 2024. If the Federal Reserve lives up to its words by the end of 2023, the base interest rate will rise to 4% and its balance sheet will be reduced by approximately $1.6 trillion, the interest on the H. The government rate for 10 years will easily reach 5%. Which will most likely bring the prime interest rate, which currently stands at 5.5% (compared to 4% in May of this year) to over 7%.
Chairman Powell’s moment of truth is approaching
The total debts of all sectors in the American economy stand at about 90 trillion dollars. Each additional percentage in the interest rate means another 900 billion dollars a year in the financing costs of the economy, about 4% of the GDP. In 2021, when the yield on the 10-year government bonds averaged below 2%, the federal government paid about 400 billion Dollar interest (8% of its budget) – according to the Congressional Budget Office. If this interest rate reaches 4% (it already stands at 3.2%), the government deficit will increase by another 400 billion dollars and with it also additional demand for credit, which is expected to further push the interest rate upwards.
By next year the Fed’s policy will begin to manifest itself in the real economy as well and the war on inflation will cease to be a fake war with no casualties. With prime interest in the region of 7% and interest on 10-year bonds in the region of 5%, many companies will be forced to lay off workers just to finance the cost of the interest, not to mention the expected slowdown in sales in such a case.
Many companies will also have difficulty raising new credit. The climbing cost of financing the growing government deficit will force the government to cut its budget or further increase its demand for money, which will also lead to credit pressure in the economy. Consumer credit will also respond to its increase in price. Interest rates on credit cards have already climbed by about 5% since the beginning of the year, and now stand at an average of 19%. When the whole economy realizes that mortgage interest rates above 7-8 percent are the new reality, the real estate market will also react accordingly.
Under these circumstances, it should not be surprising if the stock markets increase and decrease by tens of percent. Or then the moment of truth will come when everyone will see what Fed Chairman Jerome Powell is made of. Is he the new Paul Volcker or maybe just Bernanke-Yellen, pretending to be Paul Volcker for a moment.