Fighting with a no less complex 2022
Super-inflated asset prices such as housing, stocks, and bonds; massive inflation; and central banks that have started to react. Many central banks have started pushing up interest rates; others have ended asset purchases. And Quantitative Tightening (QT), central banks shedding assets is on the table.
Rising interest rates in the US won’t catch up with raging inflation in 2022. CPI inflation is now 6.8%, the highest in 40 years. But unlike 40 years ago, inflation is now on the way up. In the early 1980s, it was starting to head down. We need to compare the current situation to the 1970s when inflation was spiraling higher. So we’re entering a new environment where the economy will be doing things we haven’t seen in many decades. It will be a new ballgame for just about everyone.
As is always the case, the year-over-year inflation figures will fluctuate. CPI could go over 7% or 8% and then fall back to 5% only to jump again, providing moments of false hopes, as they did during the waves of inflation in the 1970s only to race even higher. Inflation has now spread deep into the economy, with services inflation picking up, and there are no supply-chain bottlenecks involved. This includes the inflation measures for housing costs. Those housing inflation measures have begun to surge. We know that the figures for housing inflation, which account for about one-third of total CPI, will surge further in 2022, based on housing data that we saw in 2021, and that is now slowly getting picked up by the inflation indices. They started heading higher in mid-2021 from very low levels, and they’re going to be red-hot in 2022.
This is inflation is fueled by enormous monetary and fiscal stimulus, globally, but particularly in the US (with nearly $5 trillion in money-printing since March 2020, and over $5 trillion in government spending of borrowed money). The stimulus has broken price resistance among businesses and consumers. Enough businesses and consumers are willing to pay even the craziest prices. A sign that the inflationary mindset has taken over for the first time in decades. All this stimulus has broken the dam. Inflation is not going away until central banks remove the fuel via QT to allow long-term interest rates to rise, and by pushing up short-term interest rates via rate hikes, and until these policy actions are drastic enough to shut down the inflationary mindset and reestablish price resistance among businesses and consumers.
Central banks in developed markets already hiked rates:
- The Bank of England: by 15 basis points, in December, for liftoff.
- The National Bank of Poland: three hikes, totaling 165 basis points, to 1.75%.
- The Czech National Bank: five times by a total of 350 basis points, to 3.75%.
- Norway’s Norges Bank: for the second time, by a total of 50 basis points, to 0.5%.
- The National Bank of Hungary: many small hikes totaling 180 basis points, to 2.4%.
- The Bank of Korea: twice, by 50 basis points total, to 1.0%.
- The Reserve Bank of New Zealand: twice, by 50 basis points total, to 0.75%.
- The Central Bank of Iceland: four times, by 125 basis points in total, to 2.0%.
Central banks in developing markets have been much more aggressive in hiking rates to get inflation under control and protect their currencies. A plunge in their currencies would make dollar-funding very difficult. They’re trying to stay well ahead of the Fed. Among them:
- The Central Bank of Russia: seven times, totaling 425 basis points, to 8.5%.
- The Bank of Brazil: multiple huge rate hikes, by 725 basis points since March, to 9.25%.
- The Bank of the Republic (Colombia): three hikes totaling 125 basis points, to 3.0%.
- The Bank of Mexico: five hikes, totaling 150 basis points, to 5.5%.
- The Central Bank of Chile: four hikes, 350 basis points in total, to 4.0%.
- The State Bank of Pakistan: three hikes, totaling 275 basis points, to 9.75%.
- The Central Bank of Armenia: seven hikes, totaling 350 basis points, to 7.75%.
- The Central Reserve Bank of Peru: five hikes, totaling 225 basis points, to 2.5%.
Long-term interest rates cannot move much higher until the Fed ends its QE program, which was designed to repress interest rates. The end of QE is scheduled for March. Beyond that, long-term interest rates cannot seriously rise until the Fed’s balance sheet declines. This happens when the Fed allows maturing securities to roll off without replacement. At the last meeting, Powell informed markets that the Fed is now discussing QT.
The reason why the Fed will move faster in 2022 is this raging inflation. Back in 2014 through 2016, the price of oil collapsed from over $100 a barrel for WTI to below $30 a barrel, which pushed down inflation, and there were no inflationary pressures. The Fed just wanted to normalize its monetary policy. Now inflation is raging, and the Fed needs to tighten. By a lot. And some of this will start in 2022.
What will higher interest rates mean for real estate?
Normally, in the initial phases of rising mortgage rates, there is a mini-surge in buying as homebuyers want to lock in the lower mortgage rates before they rise further. But when mortgage rates reach a certain magic level, home sales begin to fizzle, as buyers can no longer afford the payments at the higher mortgage rates and those sky-high prices. Something has to give for sales to take place: price cuts. This situation was starting to play out in 2018, particularly later in the year, like the 30-year fixed-rate mortgage rates approaching 5%. Somewhere over 4% was that magic rate in 2018 where the market started to tilt. At that time, stocks also sold off sharply.
But in 2018, there wasn’t much inflation, and the Fed could justify backing off. Now, in 2022, there’s raging inflation. And bonds puked. This time around, it’s very different: home prices have skyrocketed — up nearly 20% year-over-year for the US overall, according to the Case Shiller Index, and by 30% year-over-year in some markets. So the classic behavior of buyers jumping into the market when they see rising mortgage rates on the horizon may not happen to the extent it happened in the past.
When mortgage rates reach that magic level, which might be lower than last time given today’s sky-high prices, the volume will fizzle. For more sales to occur, prices have to come down. This starts the cycle. Lower mortgage rates lead to home price inflation. Higher mortgage rates do the opposite. They will eventually cool the housing market. Housing market downturns proceed slowly and can take many years. So in 2022, we might see the first timid beginnings in select markets.
Other property markets are implicated too. For example, back in the early 1980s, when interest rates were jacked up to crack down on inflation, the farmland bubble burst, and farmland values plunged by over 50% in some regions of the Midwest from 1981 through 1985. Overvalued farmland had been used as collateral for loans issued by specialized banks, and when those loans went bad, some of those banks collapsed.
Then in 2004, the Fed started raising interest rates, eventually rising from 1% to over 5% by mid-2006. And that’s when the Housing Bubble turned into the Housing Bust, housing prices spiraling down, and lower collateral values then triggered the mortgage crisis, and the bank collapses and the whole schmear. It’s not always clear in advance what exactly will keel over when long-term interest rates rise far enough in an overleveraged market. But one thing is clear: Some things keel over. The last time we had this inflation was 40 to 50 years ago, but back then interest rates were already much higher.
In 1973, when inflation began to surge, mortgage rates were moving north of 8%. By 1979, they exceeded 10%. By the early 1980s, 30-year fixed-rate mortgage rates were over 15%. But we cannot compare the situation in 2022 and beyond with that of 50 years ago because for much of the time since 2008, we’ve had massively repressed interest rates, massively inflated real-estate prices, and massively inflated asset prices across the board. Financial repression reigns, with “real” short-term interest rates up to junk bonds being negative. That just hasn’t happened before in my lifetime.
In terms of the housing market, there are unsavory parallels with 2005: Investors are heavily into it. And there are lots of low-down-payment loans, guaranteed by the FHA and other government agencies, with down-payments as low as 3%. Those agencies have also guaranteed many mortgages issued to subprime borrowers. But this time, the taxpayer is mostly on the hook for those mortgages, not the banks, when the market turns south. So a financial crisis of the type in 2008 is not what I see because the banks have sloughed off much of the risk to the taxpayer.
What I see is just the beginning of a downturn in asset prices, including housing but not a collapse of the banking system. The Fed, now that it has this gargantuan balance sheet, has a huge tool in the toolbox that it didn’t have 40 years ago: Trillions of dollars worth of bonds that it can let roll-off or sell outright to drive up long-term rates without even having to raise short-term rates all that much. It’s long-term rates that matter the most, and QT is designed to push them up, just like QE was designed to push them down.