There is a lot going on this week with the sequester starting, Bernanke indicating QE is not ending, and the first statistics on the effect of the fiscal cliff revealed. Our overall view has not been changed by the latest news or events. We continue to expect a long slow grind for the US economy, climbing a wall of worry as the debt crisis only slowly fades as growth moves forward. We do not see much possibility of a sudden move up in either inflation or interest rates. The headwinds are simply still too strong for this economy to get up and sprint. The fact that the fiscal cliff and sequester – and the continuing resolution and hopefully the 2014 budget – will all be worked out over the next couple of months sets the stage for less uncertainty about which headwinds we will face in the second half of the year. However, virtually any policy setting will still be a drag on the economy, either from higher taxes or less spending. The deficit should shrink by 3% over the next two years – and that is an event greatly to be wished – but it has a cost in the form of slower than normal aggregate growth. Still, after three quarters of sub-2% growth in final sales to domestic consumers, there is hope for a pick-up in domestic demand that lifts economic growth 0.5% to 1% heading into 2014.
While everyone is wondering how bad the sequester will be, we got the first statistics on personal income and spending in January so that we can see how bad the fiscal cliff was. Despite all the drama about the numbers, our view is that nothing much happened at all. The place to see the rise in taxes from both the hike in FICA and the increased marginal rates on higher income brackets is in the spread between growth in personal income and in disposable income. In January, personal income fell -3.6%, offsetting the 3.6% hike over the previous two months due to year end income shifts to beat the tax hikes. Over the last four months, personal income growth has been flat. Meanwhile, disposable income fell -4.0%, as tax hikes hit adding a modest 0.4% of drag. However, disposable income grew 3.9% in November and December, so over four months it is down only 0.2% relative to personal income. From here, personal income and disposable income should grow at roughly the same rate if no further tax hikes are involved in the solution to the sequester. In any case, consumption rose 0.2% in January (before adjusting for inflation) suggesting little immediate impact from the fiscal cliff. As a former Federal Reserve Governor reminded us last night, the FICA tax cut was always expected to be temporary, even though they extended it for a third year. Thus, the permanent income hypothesis tells us most of it would be saved, which includes using it to pay down debt. Moreover, when the tax is reinstated, the greatest impact should be on the savings rate. Until the Government revises the data (as they are want to do) it looks like that is precisely what happened.
With the fiscal cliff in the rear view mirror, the less austere sequester is now center stage in Washington. As we expected, the solution to the sequester was no solution, it has simply become law. Congress is already moving on from worrying about the immediate impact, because they know that pain will be extremely targeted and temporary – like a winter storm. The behind the door infighting is all about who yells the loudest to get their spending restored in the upcoming continuing resolution which must pass by March 27th or all federal government shuts down. So far both sides agree that a CR must be passed, and at the lower levels of spending enacted by the Budget Control Act. The question is how clean a bill will be offered. Adjustments to the sequester could be attached to the CR or offered as a separate bill. The issue all comes down to politics – which is why we are in Washington this week to attend the National Association for Business Economics policy meeting where many of the key inside the beltway players are invited to speak.
The Iron Law of Housing Finance
One of the most common questions we are asked is “When will interest rates rise?” In our view, higher rates are still a long way off, perhaps at the periphery of the two year crystal ball we keep at the office. One reason is because of the still fragile housing market and how a rise in rates could derail a still budding recovery in the housing market. We have said many times that we are not much concerned by the recovery in housing as a driver for the economy. Demographics and change in taste have dramatically altered the role of housing in our economy. New single family construction is now a $125 billion industry and even if it doubled, it would be less that 1% of GDP. Total residential investment may rise 10% this year adding 0.2% or so to GDP. Nice, but hardly a locomotive. Rather we are concerned about housing prices, because home values still represent the collateral for the bulk of loans in our banking system. As long as many mortgages remain underwater, banks will remain cautious and that limits economic growth.
Well, home prices are up 7% over the past year, so isn’t that a good thing? Obviously, but the question is why and will it continue? The reality is that home prices are up because interest rates are down. Mortgage rates have fallen roughly 10% over the past year, from 3.85% to 3.5% for thirty year conformable loans. The first thing to note is that the decline was only 35 basis points – but it made a big difference. So what would happen if interest rates reversed just those 35 basis points? Bottom line, it would not be helpful – never mind the 1% – 3% hikes some are looking for over the next couple of years. Most houses in America are still bought with a mortgage and the iron rule is that it is all about the monthly payment. If interest rates go up 10%, and your income is unchanged, then either the price must fall 10% or the deal does not get done. It is true that houses are more affordable than ever now because of low interest rates. Conformable loans now let you have a total debt ratio for housing, auto, credit card, student loan payments, etc. payments of 43% of income. A house worth 4X income at a 6% carry for PITI (principle, interest, taxes and insurance) would still allow almost 20% of income for other debt payments. It is a great time to buy a house – if you can make the down payment. Roughly half of loans are currently through FHA where down payments can still be 3%, but banks often require 20% on loans they will hold in their portfolio. Either way, a 7% increase in home prices means a 7% increase in the money needed for down payment – and at 20% of 4X income that means an additional 6% of income that had to be saved compared to last year for the same house. Sure, income went up 4% as well, but 2% of that was to offset inflation in everything besides housing (including rent) leaving little left to fund a housing boom.
Lots of the concern about rising rates is about what will happen to the Fed’s expanded balance sheet and the consequences for future monetary policy. A 1% rise in long rates hits a $3 trillion largely long term asset portfolio pretty hard. However, the Federal Reserve does not mark to market. Our concern is about what a 1% rise in long term rates does to the balance sheet of the banking system. At 1% higher rates (based on a 6% PITI carry) the monthly goes up 15% (lower principal payments cushion the blow a bit). Unless income growth is screaming or Americans renew their love affair with housing by committing a far bigger share of income to purchases – neither of which seems likely – sales will collapse and home prices will fall. The banks are levered investors in fixed income assets. A 1% rise in rates which causes a 1% fall in home price has a much bigger impact on bank capital – especially when more than a quarter of their portfolio is already underwater.
QE was designed to inflate asset values and none more targeted than home values – why else would you buy mortgage backed agency paper but not student loans? We see little chance the Fed allows interest rates to rise before the banking systems balance sheet is growing fast enough that it is accelerating loan growth. That loan growth will lead to jobs and a lower unemployment rate – and given the Fed’s dual mandate that is how the wording goes in public. But the Fed is the custodian of the banking system, and that system lives and dies today based on seemingly small basis point changes in rates that amount to big percentage shifts in capital. That is why we expect that when rates rise they will only grind higher – though perhaps with greater volatility as the financial markets over react to every modest improvement in the economy.