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AV SPECIAL BULLETIN #
are not in Kansas Anymore”
Since 2008 when then Fed Chairman Bernanke
cut the Fed Funds rate to zero, US financial
markets and consumers have been living a dream: low interest loans
rates at or below the rate of inflation. Essentially free money.
Since 2010, the FED has tried
to raise the inflation rate and get it to trend above 2.0%, but
could not. This time period
of low inflation and a Fed Funds rate of near zero, I refer to
as “Kansas”. It will soon
be apparent that interest rates “are not in Kansas anymore”.
The stock market began to
realize this in January and thus far has had a terrible year.
An old lesson is going to be retaught: the cost of capital affects
the economy and markets.
The reality is that……
We are now in a new FED tightening cycle. The last FED tightening
cycle was 2018.
From Dec 2015 through Dec 2018, the FED raised the Fed Funds rate
8 times to 2.0%,
with each rate hike a 1⁄4%. In the fall of 2018, in various
speeches, Chairman Powell
indicated that 3 more rate hikes in 2019 were possible. At the
time the FED was trying
to “normalize” interest rates, i.e., get the FF rate
back to 3.0%. The FED’s schedule
to normalize interest rates was just too much and too fast for
markets at that time. You
might recall financial markets had a horrible Q 4 in 2018. Due
to all of the ruckus, the
FED backed off and the financial markets calmed down. By July
2019, because the
economy was slowing, the FED went back to cutting interest rates
What has changed, what’s different? In 2018, the FED had
the flexibility to slow down
their rate hikes because at that time we were still in a world
of 2% inflation, but today
we have nearly 8% inflation.
THE most important monthly economic number that comes out now
is the CPI, the Consumer
Price Index. Even though the FED, on March 16th made their first
rate increase in 3 years, the
CPI has been affecting interest rates and all financial markets
In the latest CPI report on March 10th, the CPI was up +7.9% YoY.
On March 15th, the wholesale
inflation number was released, called the PPI, and was up +10%
YoY. Wholesale inflation is
seen as a precursor to the CPI as wholesale prices eventually
work their way into retail prices.
While the oil market and energy get all of the blame, price rises
in the CPI are broad based.
This means that higher retail inflation (CPI) numbers are probably
Since 2000, the CPI
has climbed +62%.
Unless you are 65+ years old, you are about to experience something
never seen in your life
time: a FED tightening cycle FORCED upon the US economy by high
inflation. This last
occurred in the late 1970’s as Jimmy Carter was preparing
his reelection campaign. Carter
appointed G. William Miller as FED Chairman in March 1978. Miller
was appointed to dampen
inflation, which at the time was on the rise. Miller inherited
a high inflation economy and high
oil prices by OPEC. OPEC was raising prices because the US dollar
was losing value due to the
higher inflation. Oil trades in US dollars. Miller was not in
favor of raising interest rates and
risking recession. Miller told Carter that a recession would make
inflation worse. By March
of 1979, it was apparent to Carter that Miller was not going to
be dragon slayer needed to kill
inflation, and save his reelection. FED Chairman have a 4 year
term and Miller was only in yr 1,
so to get Miller out, Carter appointed Miller to be Secretary
of the Treasury, which opened the door
for a new FED Chairman. In Aug of 1979, just 14 mo before the
next Presidential election,
Paul Volker was sworn in as FED Chairman. Besides being very intelligent,
not intimidated by politicians. At 6’ 6’’, when
he walked into a room, he had a real presence,
thus his nickname “Tall Paul”. Volker was also well
known for his love of cigars.
Volker in a Congressional hearing.
While known today as the man who killed inflation, and highly
respected for it, at the time of his tenor,
Volker was very unpopular- even hated and despised. History has
a way of correcting the “emotions of
This is what Volker walked into in Aug of 1979. The CPI was running
at 11.8%. It was rising almost
1% per month. Volker knew that strong medicine was needed, and
that it would be very unpopular.
The speculative behavior in the US economy needed to be squeezed
out by raising interest rates and
turning investors and consumers back into savers. This meant recession.
In Aug of 1979, the Fed Funds rate was 8.0% with inflation at
7.8%. This is an important point because
it demonstrates, that even a FF rate at the same level of inflation
did not slow it. From Aug of 1979 thru March
of 1980, the CPI moved up to 14.8%. During this same 7 mo period,
Volker moved the FF rate from 8%
up to 20%. Volker moved the FF rate up by 12%, unheard of numbers
today, let alone in just 7 months.
At the time I had my money in a money market fund at Dreyfus and
was yielding 17%. With such high
savings rates, and no risk to them, everyone became savers. By
March of 1983, the CPI was back down at 3.6%.
While Volker’s actions were effective in taking out inflation,
there was also a high cost on the economy.
The economy went into recession and the housing market slowed
dramatically becoming an “owner will carry”
market. The unemployment rate rose from from 6.0% in Aug of 1979
to 8.6% in Jan 1982, one year into
Reagan’s first term. In 1981-82, if someone had $50,000
to buy a home, he could not, because mortgage rates
were so high, he could not qualify for the loan. In 1981 mortgage
rates were over 16%. You can probably
imagine, that during this time period, Volker was under tremendous
pressure from Congressional leaders to
lower interest rates immediately, that the pain was too great.
Volker’s basic premise was that if inflation was
not defeated, and our money became “monopoly money”,
then nothing else would matter. To defeat
inflation now and set a foundation for a low inflation recovery,
the nation needed to take the pain now,
for the gain later. The foundation of low inflation that Volker
laid, lasted through 2020, 40 years.
Unfortunately, politicians have short memories, forcing all of
us to have to relearn the lessons of the past.
In view of this history, what are the implications for the present
FED? No one on the FED wants to be
remembered as the FED that let the inflation genie out of the
bottle. But too late for that, it’s out. This FED
will have to settle for getting inflation back down, hopefully
substantially. The important question to ask
though is, what rate of inflation will this FED consider a victory?
We cannot know this with certainty, but
since Chairman Powell has said several times that he wants inflation
to trend above 2.0%, we could make
a modest guess and say 3% - 4% could satisfy this FED.
What is the FED doing now? The FED has clearly stated that beating
back inflation is now their primary
goal. The labor market will have to fend for itself; no problem,
as it has a surplus of job openings.
On March 16th the FED announced their first Fed Funds rate increase
in 3 years, moving it up to .25-.50%.
The FED also announced they are stopping Quantitative Easing (QE),
the FED’s buying of bonds in Treasury
auctions to artificially support lower rates. The bond market
will revert back to a pure auction market at the
qualms of “the market”. This alone should put upward
pressure on interest rates.
The FED also owns about $9T in debt, often referred to as their
“balance sheet”. The FED did not discuss
on March 16th when they would start paying this down, but when
they do, that too is considered a factor
that will also put upward pressure on interest rates.
The FED has laid out a time table for 6 more rate increases this
year. Assuming all 6 are .25% increases,
by December that will put the Fed Funds rate at 1.75%, perhaps
2.0%. With inflation right now at 4 X this
projected FF rate, that tells you we have a serious inflation
problem, now, and in the making. And if
inflation keeps rising, above the 8% where it is now, the medicine
needed will be even higher rates.
Remember, to really kill inflation, Volker had to raise the FF
rate well over the inflation rate.
Do you think anyone on this FED has it in them to raise the FF
rate to even 4%, let alone the
8% where the CPI is now running? No they don’t, at least
Chairman Powell’s forecast for inflation is that it will
be lower in Q 4 than now. But he is also the
one who said in mid 2021 that inflation was transitory, only temporary.
Powell has since admitted
he got that wrong.
The FED’s goal here is the “holy grail” of FED
lore: the soft landing, slow inflation without a recession
If the Powell FED can do this, they will be the first FED to do
so. That alone tells you the odds are
not good for a “soft landing”.
It appears to me that the FED is banking on the supply chain backups
to improve and increase the supply
of goods, which could help lower prices, and thus help the CPI.
Combine that with a rising FF rate
and the FED is hopeful that inflation will work its way lower
in the second half of 2022. In theory,
that could work.
It’s a safe bet that no one on the FED is Paul Volker, or
probably wants to be, so in my view, the best
that this FED will do in getting inflation lower will be in the
area of 4%. Cutting it in half from
its current level would be hailed as a big victory.
To Chairman Powell’s credit, he did say, “If inflation
does not come down as we foresee, the
FED could raise interest rates more quickly.” This means
1⁄2% to 1% moves up in the FF rate,
vs the gradual approach of 1⁄4% hikes we see now.
But what if inflation keeps rising, moving higher as the FED slowly
keeps raising the FF rate?
If this happens, we could have a replay of the early 1980’s,
where FED Governors finally
realize the only way to beat inflation is to cause a recession
with even higher interest rates.
Will Powell play the role of William Miller and have to resign,
or will Powell stay on board
and become a “Volker”. To be the first to do anything
big, takes real courage. Volker was the
first to raise interest rates to recessionary levels, and do it
knowingly, but did it anyway because
he knew it was the only lasting cure. If Powell, or the next FED
Chairman, has to go “Volker”
they will have history on their side.
Implications of higher interest rates for housing and land sales.
Obviously as mortgage rates go higher, with inflation rising faster
the amount of money one can borrow to buy a home goes down. Mortgage
rates were 3% + in December. Today they are approaching 4.5%.
looking to buy a home are screaming bloody murder because they
no longer get a mortgage that starts with a 3. At some point,
as home sales
slow, home prices will start to come down. This is when you find
out who really
wants to sell their home. Face reality, this is inevitable. The
only question is, how
long will this process take to begin and how long will it last.
My bet it will begin
by June, or certainly by the second half of this year.
The FED will NOT be able to begin their next cycle of interest
rate cuts until inflation
is under control. The definition of “under control”
could vary as to other circumstances
in the economy.
What about land sales? Historically, land sales have always followed
the housing market,
but with a lag. Housing sales will slow first, then land will
follow. The lag could be up to
6-12 months. This means land sales could still be fairly good,
while the housing market
is having obvious problems. Almost all land deals are cash, no
borrowed money, so land
buyers will not go through interest rate shock at the time of
purchase like a home buyer.
If I am right on my macro picture described in the bulletin, then
2022 and maybe part of
next year, will be a much better time to sell your land, than
beyond that period.
Sometimes nothing happens for decades, the suddenly, decades happen
Questions? Need help or advice?
Call OR email.
Jim Patton, Broker
“since 1985, helping investors make
BRE # 00776290
Office, outside AV 800-270-8770
Office, inside AV 661-943-8090
Fax - 661-793-7269