Morning Report: Rising inflation means more monetary stimulus

Vital Statistics:

S&P futures4,450-3.2
Oil (WTI)109.024.39
10 year government bond yield 2.24%
30 year fixed rate mortgage 4.49%

Stocks are flattish this morning as commodities continue to rally. Bonds and MBS are flat.

The upcoming week is relatively data-light, with new home sales and durable goods as the only data points.

The Chicago Fed National Activity Index declined in February from .59 to .51. This means the economy is still growing above trend, although that outperformance is declining. Note the Atlanta Fed’s GDP Now index shows growth in the first quarter to be just above 1%, which would be considered below trend in my book.

The collapse of the Champlain Towers in Surfside Florida has Fannie and Freddie asking condo boards questions regarding deferred maintenance and for the Boards to attest that they will not be the the target of building code violations in the future. Some condo boards are refusing to answer them, or to add a addendum that they are answering the questions to the best of their ability, with no guarantee” for fear of liability. “They understand the intent,” the CAI’s Dawn Bauman told me. “But some questions are not yes-or-no questions, and condo boards usually don’t have that kind of expertise. They are willing to provide the documentation, but they say lenders should make the decisions.”

If these condo boards choose to not answer the questions regarding maintenance, then it basically makes the units in the building ineligible for Fannie and Freddie financing. The bottom line is that the number of unwarrantable condos is probably going up.

St. Louis Fed President James Bullard said he would like to see the Fed Funds rate raised to 3% this year. Bullard was one of the dissenters from last week’s Fed decision, preferring to increase the Fed Funds rate by 50 basis points instead of 25.

The combination of strong real economic performance and unexpectedly high inflation means that the Committee’s policy rate is currently far too low to prudently manage the U.S. macroeconomic situation. Moreover, U.S. monetary policy has been unwittingly easing further because inflation has risen sharply while the policy rate has remained very low, pushing short-term real interest rates lower. The Committee will have to move quickly to address this situation or risk losing credibility on its inflation target.

The point about inflation acting as an easy monetary policy is important and one that is rarely addressed. While the Fed controls the Fed Funds rate, this is a nominal interest rate, which means it doesn’t take into account inflation. Economists generally agree that real interest rates (in other words, inflation adjusted rates) are really what drive behavior. So, even if the Fed doesn’t do anything with interest rates, changes in inflationary expectations are moving real interest rates.

So, if the Fed funds rate is stuck at zero, but inflation increases real interest rates are falling, and that is stimulating the economy more. Japan had the mirror image of this problem over the past several decades. Rates were set at the zero bound, but Japan was experiencing deflation, which made had the effect of tightening an already moribund economy.

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