Dr. John Mitchell presented his most recent economic forecast at the May 7th Commercial Association of Brokers quarterly breakfast meeting. Dr. Mitchell is the classic definition of an oxymoron which is defined as a sentence composed of two seemingly self-contradictory statements. In this example, Dr. Mitchell is both a well respected economist and he is entertaining to listen to. How is that possible?
The bulk of Dr. Mitchell’s presentation was on the slow but steady recovery of both the U.S. and State of Oregon economies. There were really no surprises. His mood was one of cautious optimism with warnings of potential pitfalls that could cause issues in the future but at the present time are only concerns. Some of the good news:
New employment numbers are only 113,000 below the 2008 employment peak
8.6 million new jobs have been created during this time
The unemployment rate is down to 6.3% and is continuing to improve
Core inflation remains low in the 1.5% range
Some of the things he was concerned about:
Real GDP growth in the 1st quarter of this year was 0.1% but was attributed in large part to the bad weather
U.S. exports are down 7.8% year over year
The residential home sales are down significantly over last year
Even though the unemployment rate is improving the labor force participation rate is down from 66% of the population prior to the recession to only 62.8% today
But the more intriguing part of his presentation had to do with his comments about The Federal Reserve’s recent tapering of its Quantitative Easing (QE) policy. As you may recall QE is a monetary policy used by The Federal Reserve to increase the supply of money in the economy where interest rates are at or close to zero. The Fed does this by first crediting its own account with money it has created ex nihilo (“out of nothing”) or some would say, by “printing money.” It then purchases financial assets, including government bonds, from banks and other financial institutions which has the effect of lowering interest rates. The purchases give banks the excess reserves required for them to create new money. The increase in the money supply thus stimulates the economy.
But The Federal Reserve, under the leadership of Janet Yellin, has begun tapering its bond purchases. The Federal Reserve has been buying $85 billion of bonds a month since 2011. In January they trimmed their purchases to $75 billion, followed by $65 billion in February, $55 billion in March and $45 billion in April. Dr. Mitchell predicts that by the end of the year all asset purchases by The Fed will come to an end.
The consensus of opinion among economic experts is that rising interest rates should be the logical outcome of The Fed’s tapering of QE. The Law of Supply and Demand dictates that if you reduce demand (less bond purchases by The Fed) there is now excess supply. In order to get the market back into equilibrium interest rates on bonds should increase to entice more buyers of bonds. Instead interest rates have been slowly coming down. For example ten year treasury rates are down about 50 basis points since the beginning of the year. He then posed the question, “Why aren’t interest rates rising?”
Instead of answering this question, Dr. Mitchell continued on with his presentation. The audience was left waiting for an answer that never came. So after the meeting was over I made a beeline to him and asked for an answer to his question. He paused for a moment before giving me a couple of possible reasons:
Flight to quality due to the crisis in Ukraine. Whenever there is a crisis in the world people transfer their money from riskier investments into safer investments. Nothing is safer than U.S. treasuries.
Investors are moving money out of the stock market back into bonds. Last year the stock market rose 30 percent. Investors are beginning to be concerned that the stock market has peaked and it’s best to take the gains and park their money in bonds, at least temporarily.
Both reasons are plausible. In other words the slowdown in purchases by The Fed has been offset by increased demand for bonds by individual investors.
I believe there is a third reason that’s also coming into play: the U.S. economy has rebounded faster this year than was predicted which has led to higher tax revenues. This has reduced the amount of U.S. debt issuance. It was originally expected that the U.S. deficit for this fiscal year would be $680 billion. It is now estimated at $492 billion, a 28% decline! That’s huge.
No matter what the reasons are for the lower interest rates this can only be considered good news for commercial real estate. The days of very attractive interest rates we’ve come to expect are continuing for the foreseeable future.
Source: Quantitative Easing, Wikipedia.org; U.S. Deficit Cut by Almost One-Third to $492 Billion: CBO by Derek Wallbank, www.Bloomberg.com, April 14, 2014; Why U.S. Interest Rates Won’t Rise by Mary Gates, Seeking Alpha, April 30, 2014.