Mellow CPI - great news
The CPI was mild after removing gas prices.
In actuality, inflation for nearly all categories is still racing at a 3%+ rate. What pushed down the CPI this time was transportation and apparel. Airlines and auto companies cut prices, while clothes dropped as stores cut prices on Fall inventory and released winter wear.
What the Fed wants to point out is that 2005 had 3.6% inflation and so far in 2006 we have ~2.4% (a bit higher when you add in food and a lot higher when you add in oil). So for Fed watchers, this is a sign that inflation is moderating for now and interest rates won't be raised.
While folks will quibble with the measurements (why should oil be removed?), the point isn't the absolute level of inflation but the direction. As long as inflation continues to remain mellow, the Fed will not raise rates. Also, note that in real terms, GDP is now approaching 0%.
This sets the stage for the next phase: the housing meltdown. A bust in the housing bubble brings 3 cumulative impacts to consumer spending:
1. Sudden drop in employment. Most of the unemployment will come from a combination of construction workers and real estate agents, with another significant portion from related industries, banking and retail. Before you dismiss these as low-paying jobs, recall that these workers earned an average of $50K, so 500,000 laid off workers is $25B less in payroll (or $12.5B less available to buy goods and services). I think the firings will begin in earnest around February/March as projects get finished and cancelled.
2. Reduction in home prices reduces homeowner consumer spending. Historically, as home prices drop, people tend to be more reluctant to spend because they feel less wealthy. Most homeowners have already pulled money out of their home equity and spent it. They are less likely or able to withdraw more. That will slow a significant chunk of spending.
3. ARM refinancing. Notice that foreclosure rates have tripled since last year and are still rising? That's because folks who weren't qualified to buy their homes got financially overstretched. The effect will pick up steam as even more folks begin to get squeezed. Bankruptcies will surge next year. The net effect is, again, less consumer spending.
Consumer spending is the engine of growth. When it slows, recessions begin. This is axiomatic. The important thing to note is that the economy is already slowing before these financial stresses hit. Imagine what will happen ove rthe next 12~18 months as the economy cools down AND these stresses hit.
That is why interest rate flexibility is so important to the Fed. If it can continue to see inflation dropping, then it can consider lowering interest rates. A lower interest rate helps companies and helps individuals who have ARMs resetting, for example. Do not expect a repeat of the 2001~2004 cycle when rates were cut and everybody splurged. Far too many people have overcommitted - to home loans, HELOCs, and 12 months free financing on that new couch. The recent economic boomlet was, if anything, bringing future spending into today.
In the meantime, the market should be happy with cooling inflation, but wary because it is actually a sign of worse things to come.
In actuality, inflation for nearly all categories is still racing at a 3%+ rate. What pushed down the CPI this time was transportation and apparel. Airlines and auto companies cut prices, while clothes dropped as stores cut prices on Fall inventory and released winter wear.
What the Fed wants to point out is that 2005 had 3.6% inflation and so far in 2006 we have ~2.4% (a bit higher when you add in food and a lot higher when you add in oil). So for Fed watchers, this is a sign that inflation is moderating for now and interest rates won't be raised.
While folks will quibble with the measurements (why should oil be removed?), the point isn't the absolute level of inflation but the direction. As long as inflation continues to remain mellow, the Fed will not raise rates. Also, note that in real terms, GDP is now approaching 0%.
This sets the stage for the next phase: the housing meltdown. A bust in the housing bubble brings 3 cumulative impacts to consumer spending:
1. Sudden drop in employment. Most of the unemployment will come from a combination of construction workers and real estate agents, with another significant portion from related industries, banking and retail. Before you dismiss these as low-paying jobs, recall that these workers earned an average of $50K, so 500,000 laid off workers is $25B less in payroll (or $12.5B less available to buy goods and services). I think the firings will begin in earnest around February/March as projects get finished and cancelled.
2. Reduction in home prices reduces homeowner consumer spending. Historically, as home prices drop, people tend to be more reluctant to spend because they feel less wealthy. Most homeowners have already pulled money out of their home equity and spent it. They are less likely or able to withdraw more. That will slow a significant chunk of spending.
3. ARM refinancing. Notice that foreclosure rates have tripled since last year and are still rising? That's because folks who weren't qualified to buy their homes got financially overstretched. The effect will pick up steam as even more folks begin to get squeezed. Bankruptcies will surge next year. The net effect is, again, less consumer spending.
Consumer spending is the engine of growth. When it slows, recessions begin. This is axiomatic. The important thing to note is that the economy is already slowing before these financial stresses hit. Imagine what will happen ove rthe next 12~18 months as the economy cools down AND these stresses hit.
That is why interest rate flexibility is so important to the Fed. If it can continue to see inflation dropping, then it can consider lowering interest rates. A lower interest rate helps companies and helps individuals who have ARMs resetting, for example. Do not expect a repeat of the 2001~2004 cycle when rates were cut and everybody splurged. Far too many people have overcommitted - to home loans, HELOCs, and 12 months free financing on that new couch. The recent economic boomlet was, if anything, bringing future spending into today.
In the meantime, the market should be happy with cooling inflation, but wary because it is actually a sign of worse things to come.
posted by Andrew at
9:52 AM
2 Comments:
First, I am bearish on the residential real-estate. I have been reading about the bubble bust etc on several blogs since almost 9-10 months now. Since the real-estate prices have sky-rocketed for the past 5 years, the different blogs and the media were painting the picture as though the real-estate will collapse similar to the dot com bust. Since then, I have changed my view, I don't think the home prices will reach the 2001-2002 levels atleast in the bay area. Far too many people are bearish on the real estate, and if this continues, I don't think the real estate prices will fall.
Agreed. As you know, we have been on the sidelines for almost 3 weeks now. Partly due to my hopes for better buy-in prices post Thanksgiving (after earnings season, nervousness about consumer spending surfacing, GDP re-stated down).
Here's why 2000 prices are inevitable IMHO. First, basic affordability. The Bay Area historically has a premium. Measured as median salary to median home prices, the Bay Area ranges from 3.5X to 5X at the highest. Today it is 10x. Even a 50% drop returns us to 5x, the high point right before the last housing crash in 1990. To get to 4x, housing prices must drop 60%, or stay flat for 5 years and drop 40%.
But that's history and we could be the first ones to have a new reality.
If someone chooses to sell a house today, they are either looking at a fat profit or a fat loss. What most people forget is the fees to sell a house: 6%. (It will probably drop to 5%, but we'll use the standard 6%). We are already at 2004 prices. Anyone hoping to sell their house at a 2004 price must deduct the 6% fee - voila, 2003 prices. That 6% fee is nothing as long as prices rise faster, but it really adds salt in the wound when prices drop. In the Bay Area, 6% for a house is an easy $40K, and typically $60K.
There are two kinds of homeowners: post 2002 and pre-2002. A lot of people owned before the run-up and they are sitting on nice profits even at 50% price drops. They don't have to sell, but they aren't losing money if they decide to sell.
For the others who are overstretched financially, the question is what will make them sell at a loss. What kind of fire sale? I suggest that re-financing is such an event. As is layoffs during a recession. As is the end of home speculation that drove the prices up in the first place.
The Bay Area survived the gutting of manufacturing and the end of shady dot.com companies. A recession this time will probably lead to more moderate layoffs, say trimming employee rolls by 10% to reduce expenses.
But when home sales are dropping already 30% and the inventory is increasing faster, a drop in demand of 10% is pretty impactful.
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