Navigating By the Stars Under Cloudy Skies

The U.S. economy continues to defy expectations, confound forecasters and generally throw head fakes. Starting in early 2022, the Federal Reserve embarked on its most aggressive campaign of inflation fighting in decades. The Fed’s inflation war was expected to result in a recession. Instead, the economy keeps firing on all cylinders – unemployment remains below 4%, inflation is above 3% and stocks and home prices remain near record highs.

U.S. Bureau of Labor Statistics via St. Louis Fed

With those mixed signals causing confusion among investors and economists, all eyes turned to Fed Chairman Jerome Powell, who traveled to Jackson Hole, Wyoming, for his annual address at the Kansas City Fed’s economic symposium.

Powell hinted that more rate hikes are coming – but he didn’t promise anything. In fact, Powell suggested he’s just as baffled as everyone else. “As is often the case, we are navigating by the stars under cloudy skies,” Powell said in his Aug. 25 address.

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The inflation picture: Improving, still murky

The COVID pandemic unleashed the highest inflation since the early 1980s, and the Fed was caught very much by surprise. Powell initially misread the situation, infamously characterizing rising prices as “transitory.” But by June 2022, the U.S. inflation rate topped 9%. But Powell quickly changed his tune, and from early 2022 through July 2023, the Fed pushed rates from zero to 5.25%.

As of July, the official inflation rate was 3.2%, but Powell said in his Jackson Hole speech that the central bank isn’t ready to stop raising rates.

“It is the Fed’s job to bring inflation down to our 2% goal, and we will do so,” Powell said. “We have tightened policy significantly over the past year. Although inflation has moved down from its peak — a welcome development — it remains too high.”

Of course, Powell faces a high-wire act. Or maybe he’s like a driver on a slippery road – the Fed needs to pump the brakes just hard enough to slow the economy and tame inflation, but not so hard that the vehicle spins out of control. Powell twice deployed the phrase “proceed carefully” – an indication that he plans to tap the brake pedal rather than stomp on it.

In his remarks in Jackson Hole, Powell acknowledged that the economy isn’t easy to control. And his remarks were carefully crafted in a way that gives him plenty of wiggle room for the next Federal Open Markets Committee Meeting Sept. 20.

Powell seemed to be keeping his options open, said Krishna Guha, vice chairman of Evercore ISI. Guha told The Wall Street Journal that Powell seemed “like a man who thinks he is probably done raising rates and sees a stern tone as providing hawkish aircover for shifting gradually.”

In a classic example of a two-handed economist giving an evasive answer, Powell hedged his bets. “Two months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal,” Powell said in his speech. “There is substantial further ground to cover.”

While Fed policy generally is achieving its goal of reining in prices, July’s inflation report was a new wrinkle. The consumer price index (CPI) ticked up to 3.2% — not a terrible reading given recent history, but above the 3% result in June.

The relationship between inflation and asset values is complicated. Inflation creates tailwinds for real estate valuations and can spur higher rents. On the downside, inflation leads to higher interest rates, which means the cost of borrowing to buy property goes up, and higher wages.

Elsewhere in the economy

The Fed’s muscular response to inflation over the past 18 months signals the end of an era of super-low rates in the U.S. To cite one example, residential mortgage rates have soared to their highest levels in more than two decades.

Mortgage company Freddie Mac said that, as of Aug. 24, mortgage rates averaged 7.31%, their highest point since 2001. Notably, it was the Sept. 11 terror attacks in 2001 that prompted Alan Greenspan, then the chairman of the Federal Reserve, to slash interest rates and then keep them low even as the housing bubble of 2005 and 2006 inflated. When Greenspan’s post-retirement autobiography was published in 2007, he included the revelation that the Fed rate cates reflected his assumption that terrorists would strike again. “Like most people in government, I fully expected more attacks,” Greenspan wrote in The Age of Turbulence.

In a headwind for commercial real estate, work-from-home trends continue to take a toll on the office market. In the second quarter, the average U.S. office lease size was 3,275 square feet, or 19% less than the average lease size between 2015 and 2019, according to commercial real estate data firm CoStar.
More than half of office leases signed before 2020 have yet to expire, The Wall Street Journal reported, and the U.S. office vacancy rate rose from 9.5% before the pandemic to 13.2% now. CoStar expects office vacancies to top 17% by the end of 2026.