MNI INTERVIEW:Housing Cost Lag To Drive Inflation As Fed Hikes

U.S. unemployment looks set to rise substantially even if the Fed manages to steer the economy into only a shallow recession, though a continuing rise in a measure of housing costs could make it harder to avoid more drastic monetary tightening, Fannie Mae chief economist Doug Duncan told MNI.

The likely coming downturn could be more severe if inflation does not respond to Federal Reserve rate increases, Duncan said in an interview, ahead of an FOMC decision largely priced in by markets as a 75-basis-point hike.

“When I say mild, if you measure that by unemployment, I’m suggesting unemployment might reach something like 6%,” he said. “Some people would say that’s not mild. My response to that is unemployment today is well under what economists for a long time felt is normal.”

As 4.5% joblessness would currently be consistent with sustainable employment, Duncan said, a 1.5 percentage point increase in the rate would be historically consistent with a mild downturn. However, uncertainty is high and things could get worse fast.

“If the Fed raises sharply and inflation continues at 9% for another couple of months after the Fed makes a couple more moves, then I’d be talking about a more serious recession,” Duncan said. The surge in house prices during the pandemic will make the Fed’s job harder because of the way the housing component of inflation is calculated, based on a measure known as owner-equivalent rent, he added.

“It suggests we’ll see the housing contribution to inflation to continue to grow until at least the middle of next year,” he said. U.S. CPI jumped 8.6% in the year to May and the shelter component of core inflation surged 0.6% on the month alone, the biggest increase since 2004. (See MNI: Inflation Expectations Already Unmoored -Ex-Fed Officials)

“The Fed will be leaning against that, among other things, in their effort to get inflation back down to their target levels, which we don’t think they’ll be able to accomplish without a recession.”

HOUSING DOWNTURN

Even as shelter inflation persists, Duncan said the slowdown in housing that’s already taking place amid sharply higher mortgage rates is likely to become more pronounced later in the year.

“This is the largest increase in the shortest period of time in mortgage rates since 1981,” he said. “The idea that would happen and not have a significant impact on the mortgage market to us just seems pretty unrealistic.”

Against that backdrop, Fannie Mae has “significantly” revised down its expectations for the market, forecasting an 11% decline in total home sales for 2022 after a record 2021. Further downgrades are likely, Duncan said.

This could prompt price declines in bubblier markets in particular.

“There may well be an increment of house prices that may have been supported by monetary policy,” Duncan said. “If you’re going to see broad-based outright declines in house prices, that would be one of the primary engines for that.”

FED MBS SALES LOOM

Duncan said the Fed may well opt to sell some of its holdings of mortgage-backed securities as part of its effort to reduce a USD9 trillion balance sheet, though he added that this might not come immediately.

“Our sense is if things are tightening pretty significantly and housing is slowing pretty dramatically this fall, they’re likely to wait until the beginning of next year to sell to increase the pace of portfolio runoff,” Duncan said.

Quantitative tightening is no easy task, he added, and is complicated further by a lack of certainty among Fed officials as to its exact impact on the market as well as by the range of assets on the balance sheet.

“The Treasury component has much more near-term maturity than the MBS portfolio, something like USD3 trillion in the next 24 months. That’s a question of where they reinvest on the yield curve,” Duncan said.

“To the extent with MBS runoffs that there’s a big difference between the prepay speeds in GSE MBS versus Ginnie Mae MBS, and there is a question of whether they care whether they maintain the current balance between Ginnies and GSEs,” he said, referring to securities issued by government-sponsored enterprises and by the Government National Mortgage Association. “They haven’t said whether they care about that.”