2024-03-21 18:10:23
There are four fairly quick notes on this Fed meeting day, and not all of them have anything to do with the Fed:
1. Lower average expectations of interest rate cuts
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The Federal Open Market Committee (FOMC) today announced that it is currently maintaining its policy on the overnight interest rate, the pace of the runoff in the second quarter, and the committee’s consensus forecast for the number of interest rate cuts through 2024 (three 25 basis point cuts). But it is worth noting that although the forecast indicates an average of three cuts, the average forecast has fallen significantly.
Only one official expects four rate cuts in 2024, compared to five officials who expected as many as many, as of the December survey. These four people were reduced to “three,” and the “three” people were reduced to “only one.” Nine of the nineteen points go to fewer than three cuts this year, so we think this forecast is closer than the market thinks.
2. The price is unlikely to return to zero overnight
The longer dot plot also shows some increase in committee members’ expectations for the short-term neutral interest rate (or so-called “R-Star” originally popularized by Greenspan I believe). The importance of this for investors and traders is that the overnight interest rate is unlikely to return to zero unless we experience another massive disaster; Its importance to the economy is essentially zero, because money, not interest rates, is what matters.
I’ve written before about why there are good reasons to think of 2-2.25% or something like that as the long-run neutral real interest rate, so if CPI inflation is expected to be between 2.25%-2.5%, then 4.5% is a neutral rate for the nominal rate in the long run. We are very close to that now, so there is no compelling reason to believe that interest rates will have to fall significantly from here.
At the short end of the curve, we should eventually decline – but we also have to keep in mind the growing imbalance between supply and demand for Treasuries, which (absent a recession) will tend to keep interest rates on government paper, Higher than they would otherwise be in equilibrium – and as a result, credit spreads will tend to be lower than they would have been without a given level of creditworthiness.
3. The Federal Reserve’s confidence in the commercial real estate sector and its impact on the banking sector
It is clear that the Fed believes that the situation in the commercial real estate sector and its impact on the banking sector is manageable. If they don’t think so, they will rush to cut interest rates to ease the refinancing problems hitting the sector. I’ve been reading alarming analyzes that say the trillion-dollar mortgage payments due this year will bankrupt hundreds of banks. This falls within the school of analysis that states that “a large number is bad and scary.” A trillion is also considered a large number of mortgages and this would cripple banking services!
Let us assume that 20% of these mortgage loans become insolvent – a larger number than ever before – and that the recovery rate reaches 80%. For reference, in the 2008-2009 crisis, CRE values fell by around 36% according to the Green Street Commercial Real Estate Price Index (chart below), and this was against a backdrop of inflation reaching 1%.
The decline in nominal prices should be lower in an environment with core inflation at 4% per year, of course. Since CRE’s peak, real values have fallen by 31%, but nominal values have fallen by only 21% based on this index. But falling from the top is not the relevant part.
Even the shorter-term loans that are now due were repaid three to five years ago, and the decline below this level has not exceeded about 9%. In addition, the initial loan-to-value levels were not 100%. So (and this is all just a rough estimate) a 20% loss on selling collateral on a defaulted mortgage seems conservative.
These numbers mean that $1 trillion in mortgage liens could result in a loss of $40 billion (1000 * 0.2 * 0.2). This is still a large number, but remember that it is common in many banks. Let us assume that they are distributed among only two thousand banks, and that the losses have nothing to do with the size of the bank. So you’re looking at losses per bank of $20 million. This is bad for a small bank, but losses in a small bank will of course be lower because they have smaller books. Will this flood “hundreds of banks”? Only if they are small and fairly insignificant banks.
Do some banks fail because they lent too much on commercial real estate that had fallen in value, at too high loan-to-value ratios, and ended up owning properties they could not sell? Absolutely. But after negotiations, forgiveness and eventual foreclosure – in an environment where the price level is rising at 4% per year – I don’t think this is something we should worry about. To be fair, the fact that the Fed isn’t worried about this is what makes me worry about it.
4. Jet fuel prices are rising again, causing the CPI to rise
I was puzzled recently because CPI airfare prices were higher than expected given the movement in jet fuel prices. In hindsight, I think I know what’s going on. The problems with Boeing’s planes (NYSE:) meant that Boeing (didn’t I know it) had dramatically reduced its deliveries to airlines while resolving problems with its MAX jets.
I only realized this recently when a Bloomberg story highlighted how Southwest (NYSE:) is cutting capacity and freezing hiring because it’s not getting the planes it needs. Constant demand and supply constraints also mean higher airfare prices, as I discovered this week when I was booking a flight to Chicago.
Yikes! With jet fuel prices also rising again, this is something to be factored into future CPI forecasts. To be sure, it’s “temporary,” but building an airplane takes a long time, and this problem is more likely to be solved in the near term on the demand side if we have a recession, rather than on the supply side with a sudden influx of planes.
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