posted on 23 November 2016
by Gene D. Balas
A rhetorical question - but not a prediction - what if the new administration’s stimulus plans, if approved by Congress, have unintended consequences? There is much that needs to be fleshed out in coming weeks and months, but the market has already cast its verdict on the plan, with a spike in yields on government bonds recently and a jump in inflation expectations embedded in TIPS pricing. Equity markets, likewise, are banking on more assertive growth, at least for now.
But what if the risks come from within, that is, from the very stimulus itself? Setting aside the separate discussion of trade policies, we’ll discuss two primary channels through which the increased budget deficits that would come from a large stimulus program can dent the economy. These include the effects of:
Inflation, interest rates and currencies
As it is, yields on the 10-year U.S. Treasury note jumped by roughly 45 basis points or so following the election, according to Dow Jones data. The Wall Street Journal U.S. Dollar index surged about 2.8% in that period.
However, both the dollar strength and the rise in interest rates are intertwined, as higher rates often lead to a stronger currency. Rates tend to rise through some combination of higher inflation expectations and a greater amount of supply relative to demand for bonds, such as when budget deficits are increased substantially (as would be the case in a large fiscal stimulus program). As to inflation, what we can infer from the market’s movement is that it may be around the corner, as we see in the following chart illustrating the inflation expectations in the five years beginning five years from now, which are embedded in TIPS pricing.
How will housing be impacted?
So far, we’ve simply recapped what the market already knows. Now let’s go a step further, the one venturing into the lesser explored path of how an accelerator can also be a brake. Let’s start with interest rates. As we noted, the 10-year Treasury yield rose by roughly 45 basis points or so in the past week, and that is the benchmark for many conventional mortgage loans and some corporate bonds.
What happens when mortgage rates rise by, say, the 30 basis points they did in the past week, according to Dow Jones data? Well, monthly payments go up, of course, so a house becomes less affordable. As it is, home prices have already near to their 2006 peak, according to the Case-Shiller National Home Price index. True, some of this increase in home values occurred when rates were as high, if not higher, as they are now.
But homes are already much pricier than they once were, and a simple mathematical calculation means that the increase in mortgage rates we’ve already seen to 3.9% from 3.6% means that a would-be homebuyer would find that same monthly mortgage payment would afford 3.6% less house. If home prices were to decrease by this amount, hypothetically speaking, that would mean a loss in consumer wealth by about $809 billion, given that owner-occupied real estate is a $22.3 trillion asset class, in data from the Federal Reserve. That could reverse the psychological benefits that may have been encouraged by lower taxes and stronger initial growth.
We need not even mention the effects of rising interest rates would have on fixed income investors, who will see their bond prices tumble. Note that households and nonprofits own $4.2 trillion of fixed income securities (not including cash equivalents) of varying maturities - not to mention fixed income ETFs and mutual funds - according to Federal Reserve data.
What are the effects of the dollar and rates on businesses?
Then there is the dollar, which tends to increase along with the expectations for higher interest rates, as greater returns from higher interest rates makes holding the currency more attractive. In turn, a stronger dollar means lower repatriated profits for multinationals, and less competitively-priced exports harm businesses with sales abroad - and their suppliers, too. Lower profit growth coupled with higher interest rates - and their effects on valuations - could hamper equity returns for some stocks. Simultaneously, it makes corporate budgeting for both capital and labor a more complicated endeavor. A drop in profits leading to falling share prices coupled with reduced hiring and investment would not be to the economy’s benefit.
So, what might happen if household wealth were to decline, or at least stagnate, from the effects of rising interest rates? That could slow consumer spending, meaning that some of the stimulus program would be offset.
And the same goes for corporate capital investment and hiring. If businesses are concerned about rising rates, a stronger dollar, or both, any downshift in the business sector could also slow the economy.
The end result is that you might be near where you started from. It isn’t easy to simply make growth just happen; there are a lot of complicated, interrelated variables at play. And some of those are the unintended consequences of a built-in brake from the stimulus accelerator. In the end, that’s what makes the job of an economist so much more difficult than that of a politician.
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