Why the Federal Reserve will have to cut rates sooner than we think

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Predicting the Fred’s next move given an unusual combination of a banking crises of trust, high headline inflation, a jobless number that whether is high of low will have to be judged in the context of the banking and potential liquidity crises and thus might seem like a flip of the coin, and a array of international uncertainties from the Ukraine war to the BRICS countries announcing a new currency to bypass the Dollar as a reserve currency has most economists heads spinning.

While we live in the land of VUCA - Volatility, Uncertainty, Complexity and Ambiguity - it seems that two factors will result in the Fed needing to slash rates by the end of the summer. 

I. Inflation isn’t as high as you think it is 

While inflation still looks like a sleeping dragon, if we look at the rental component of CPI the real inflation number adjusts downwards significantly. 

The rent component of CPI is 33% of the headline CPI number, food is already dropping, 

The method of measuring rental costs by the government is archaic and has a 4-7 month time lag. After looking at the actual numbers reported by on the ground large real estate developers with millions of units gives us the following divergence between real rent increase and reported rent increase 

The blue line is actual rents, the red line is what the govt is reporting. There’s a lag in the way the government measures rental data, so while it reported that rentals rose at almost a 10% annualised rate, the rental inflation actually fell to 4%. If you correct for just this lag it takes Headline CPI numbers down to 2.6%. 

The methodology for the rental survey started in 1981, before the Internet, and they’ve updated it a few times but they could go on apartments.com and see the actual asking and transactional value of apartments and homes. Alternatively, there are massive real estate companies with hundreds of thousands apartments on rent and can accurately model real time changes and predictions. 

Instead, they have someone who calls you at dinnertime for a quick chat. If someone calls me at dinner and asks me how much I would rent my home out for, I would hang up. Rental inflation is substantially falling and the Fed is yet to catch the lag effect. This also explains why the Fed was in retrospective slow in raising rates. When rates were sky high in 2021, the Fed was reporting low inflation because of the lower rental inflation numbers at a time when the world was opening up, people were moving back out of their parents homes and back to the cities, and we had double digit rental inflation in some parts of the country, but the Fed’s calculations didn’t catch that until the middle of 2021. By the middle of the summer, these lower rental rates will catch up and a lower headline inflation number would result in a potential rate cut. 

II. The lack of trust in the banking system has amplified the effect of rate hikes by removing more liquidity per basis point hike than was anticipated 

Between December 2021 and now $750b has left the banking system for money market funds or directly into treasuries. Money market funds have been matching the Fed Funds rate while banks are still only providing marginally higher rates on deposits. The collapse of SVB and Signature Bank more than anything drew attention to the increased interest rates that caused the mark to market losses for the banks. Out of $750b , $600b was from the “Systemically important institutions” ie too big to fail, and half a trillion dollars of this was added to the money market in the last 30 days alone. Money markets in turn also hold their assets in treasuries, which funds the government, but has an additional drag on lending as banks have to tighten their credit standards due to less money in their system to lend out. 

The crises of trust, which I think is a more accurate terminology than “banking crises”, has removed more liquidity from the economy per basis point hike because of an amplifier effect by the attention in extra yield from money market funds vs the banking system. Bringing the spread in interest rates to the attention the average investor has put the removal of liquidity from the system from rate hikes on steroids. The estimated drag on the economy caused by tightening credit standards, according to Oxford Economics, is estimated to be 0.8-1.5% in the next year 

Between the lag in rental inflation data finally showing up in the headline number and a massive outflow of money from the baking system will show in a sudden crash in the headline inflation number all things being equal by late summer. The wildcard is always energy because we can’t predict a move like OPECs cut in oil production today. 

In the end however, once the fed catches up with the lag from rental decreases and simultaneously there’s an under supply of liquidity for credit worthy businesses, the fed will be in a bind if they miss the boat and don’t cut rates in time.