What Friday's Job Report Means for the Months Ahead
On Friday, the Labor Department released its monthly jobs report, which showed an estimated 467,000 news jobs were added to the economy in the month of January. The report also upwardly revised the previous December estimate from 199,000 new jobs in that month to 510,000 new jobs, which is a pretty significant change to the upside.
The report on Friday was strong and unexpected. According to a Bloomberg survey of economists, there were only predicted to be 125,000 new jobs created in January and in the entire survey the highest prediction was that 250,000 new jobs would have been created. The actual report blew the estimates out of the water.
Friday’s report has two major implications that set the table for the months ahead:
The economy continues to improve despite omicron wrecking havoc over the past month.
Interest rates are inevitably going up, probably as soon as March and possibly more significantly than people have been expecting.
Why Interest Rates are Going Up
Keep in mind that the Federal Reserve, which largely controls interest rates, has the following mission per the Federal Reserve Act that established it: “To promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Even though this list includes three items, items #2 and #3 are typically considered to be one concept and the above description of the Fed’s responsibilities is commonly referred to as its dual mandate. In short, The Fed’s mission is to promote employment and control inflation.
Since the outset of the pandemic, Fed officials and others in Washington D.C. have been more concerned about maximizing employment than moderating prices. The reasoning behind this was, of course, that people were struggling amidst the uncertainty of COVID-19, businesses were closing, and not only were people hurting but there was the potential for massive ripple effects throughout the housing market and elsewhere if the job market were to collapse.
The fiscal policy decisions to tackle this issue included massive stimulus programs for both businesses and individuals. Monetary decisions included the ratcheting down of interest rates, which was meant to stimulate economic activity. At lower interest rates, people can better afford things like homes and cars, people can refinance their existing debt to lower rates saving money on a monthly basis in the process, and businesses and non-profit organizations can borrow more to expand operations, acquire new assets, or simply stay afloat and keep workers employed.
Even as inflation started to creep up, however, interest rates have been held at historically low levels. President Biden, (primarily) Democrats in Congress, and officials at the Federal Reserve all hypothesized that inflation was “transitory,” which meant that it was being caused by COVID-related supply chain issues and other general oddness in the economy due to the ongoing pandemic. Undoubtedly those massive supply chain challenges played into it. But as I wrote last June as inflationary pressures started to become evident, “There is a risk of overheating in all this. Significant government stimulus + a snapback economy + rising wages + leveraging up of corporate debt feels to me like a formula for inflation.” And that is what we now face.
So what does this have to do with Friday’s jobs report? Well, the employment situation right now is stronger than anyone expected it would be. With that side of the Fed’s ledger in a more positive place, it can focus on the other half of its dual mandate: controlling inflation.
The Fed’s stated policy is to promote monetary policies that keep inflation at a rate of around 2.00% per year. The graph below shows the inflation rate on a monthly basis over the last ten years. For much of the last decade the rate did actually hover around that 2.00% figure:
The chart above also underscores another reason why the Fed was eager to stoke employment versus control inflation during the first year of the pandemic: inflation from March 2020 to February 2021 was actually running below the Fed’s stated 2.00% goal and, indeed, it has been a long time since this country has experienced any sort of meaningful inflation.
But what now? Well, inflation is clearly running hot. The Fed will now seek to reign that in and the primary way they will attempt to do that is by raising interest rates. The conventional wisdom now is that the Fed will raise its Federal Funds Rate by a quarter point in March and then do so again in May or June if not May and June. There is even talk that the Fed might actually surprise with a half-point increase in March as the risk of runaway inflation seems greater than the risk of a breakdown in the employment market at this point.
And, in fact, banks nationwide are already pricing in interest rate hikes. Here is the chart of the average fixed rate on a 30-year mortgage, which is already starting to jump since just December:
What Does This All Mean?
The major implication in this is that the cost of borrowing is going up. Home loans, car loans, business loans: interest rates are going to rise. This could potentially have a dampening effect on the housing market as people will not be able to afford as large of homes at, say, a 5.00% interest rate versus a 3.00% interest rate. On the other hand, demand for homes is very strong right now and low interest rates are just one of the reasons why. Other variables remain that should provide strength to the housing market even despite rising interest rates including a demographic shift of more younger people coming of age and entering their peak home-buying years and the fact that the pandemic lead many Americans to look inward at their own homes and reconsider where they even want to live. Nonetheless, rising rates will almost certainly have an effect.
The other impact will be on variable rate loans. As rates go up, so too do interest costs. As interest rates rose in the middle to latter part of the 2000s, many homeowners with variable rate mortgages suddenly found themselves with monthly payments they could no longer afford, which led many to default, which then of course had a cascading effect through the rest of the economy as banks had collateralized these loans into risky packages and sold them as investments that then started to go bust.
Fortunately today more homeowners have fixed rate mortgages for the life of their loans (it helps when the starting rate that is fixed throughout is around 3.00%, which is very attractive and where rates have been for the past couple of years). So homeowners are not at as great a risk of having their payments jump up due to rising rates. But in my work as a commercial lender, I can say that many loans for businesses have a variable component to them. It is important for borrowers to calculate their expected cash flow (and therefore the viability of the venture) based on their debt service payments at current interest rates but also at expectations of future rates. A business concept, the income from an investment property, or all manner of other commercial ventures might adequately cash flow at current rates but what if rates double? Certainly the cash flow is not going to be as attractive and for some the venture might lose some or all of its viability.
Economies evolve and time passes. It goes without saying that we will look back at this period of time as particularly unique because of the pandemic. But as the pandemic eventually subsides or at least becomes manageable, the lingering effects of the decisions of the past two years and how the economy and its various players continue to react to them will remain.
Ben Sprague lives and works in Bangor, Maine as a V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram.
Weekly Round-Up
It’s worth noting that inflation is high in many places around the world right now. It is not just a U.S. phenomenon. Turkey and Argentina are running off the charts at rates of inflation of 50%, Brazil and Russia are around 10%, Spain and Mexico are similar to the United States around 7%, and Canada, the United Kingdom, Italy, and India are all around 5%. Where is inflation low? Japan, Saudi Arabia, and China all report inflation rates around 1% and France, Australia, and South Korea are all just under 4%.
Over one third of all homes on the market in December here in the United States were new construction, a record high! I wrote just recently about whether the private sector can close the housing gap. It seems they are trying. Per Redfin:
Newly built homes have taken up an increasing portion of the U.S. housing market over the last 10 years, with a major acceleration in mid-2020 after the pandemic began. Homebuilders have been busy trying to make up for the lack of existing homes on the market and keep up with high demand. There has been a surge in homebuyer demand since the start of the pandemic, stemming from low mortgage rates and the prevalence of remote work. At the same time, some homeowners have opted to refinance or remodel instead of selling, intensifying the shortage of existing homes for sale.
Charlie Warzel writes in The Atlantic about Web3. He touches on a number of things I have been feeling myself. Is Web3 (including digital blockchains, NFTs, cryptocurrencies, and the like) the future of the internet or it is a speculative gold rush with Ponzi-like tendencies? Warzel writes:
Perhaps worst of all, I find so much of Web3 deeply inaccessible. When I took the time to set up a crypto wallet and participate in the new economy, the experience was devoid of thrill. I didn’t feel that sense of hope and potential that came when I first logged onto the internet, logged into Facebook, downloaded a song on Napster, or held a smartphone in my hand and checked my email away from a computer. That itself can feel sad, even unsettling, given Web3’s revolutionary framing.
Like Warzel and I am sure a lot of you, I don’t want to be left behind, which can lead to feelings of both ignorance and FOMO (Fear Of Missing Out). And unwise decisions including investment ones are often made when experiencing those two emotions, so my default is to be cautious.
Alex Thomas shares a chart showing that cycles of interest rate hikes (like we are about to experience) are frequently followed by recessions.
One Good Read
Author’s Note: people have really seemed to like this section of the newsletter, which I am glad about! Please send me your recommended articles, particularly long-form pieces. They do not even need to be about the economy and real estate - I’m just looking for interesting, well-written pieces. I want to read them myself, but I will also feature them here along with the person who sent it to me. Email me at bsprague1@gmail.com or ben.sprague@thefirst.com or drop a comment below.
From Kim Bhasin in Bloomberg, ugly shoes are big business. The pandemic has driven a boom in pragmatic, comfortable footwear, which has boosted the business of Crocs, Ugg, and even lead to a retro comeback for Teva (which I personally had not heard of since roughly 1998 and would have assumed the company no longer existed). And as the author notes, lately the uglier the shoe the better it is selling.
Got story ideas or news tips? Email me at bsprague1@gmail.com or ben.sprague@thefirst.com. Have a great week, everybody!
I am embarrassed by how many times I tried to adjust the slider on the screen capture with the two years of interest rates... haha! Really good points about analyzing future cash flows at different (higher) interest rates when projecting commercial property performance. Last loan I close, I chose to pay a higher rate for a 10yr adjustable instead of 5 year to reduce some potential volatility and hedge a little bit against extreme rate hikes. Tough to pay .25% or .5% extra but if rates rise by 3-5% it won't seem like anything.