3 things – inflation, interest rates, mortgage myths

Here are some things I'll be thinking about at the end of this weekend.

1) Team Transitory won (Not)!

It has been over 3 years since I explained why the term “transitory” should not be used. And yet Paul Krugman still claims inflation is transitory. Only now he calls it “long transitory.” The basic narrative is that the inflation rate is now back to its pre-Covid level. It was all “transitory” and just lasted longer than expected. But I find that narrative quite disingenuous because the entire reason for claiming inflation was transitory was based on the theory that inflation was purely supply-driven. That is, inflation would be self-correcting and “transitory,” which would not require a major policy response. That was the Fed's mindset in 2021. But when it became clear in 2022 that inflation was not just supply-driven, the Fed felt the need to abandon the transition narrative and fight inflation with an aggressive demand response.¹

The “long transition” narrative completely distorts what happened over time and why the Fed and other economists said inflation was transitory. As it turns out, we now know that the huge government spending actually created excess demand that required a major policy response. And so the inflation rate fell, but only because the Fed abandoned the transition rationale and realized that an aggressive demand response was necessary.

And look, I'm not trying to downplay the very real economic progress we've made over the last few years. Things have been going better than expected. But I also think it's a little bit unrealistic to ignore the very real burden that this inflation has placed on people over the last few years. At the same time, it's important to critically analyze the causes and responses here, because the economists who said fiscal policy wasn't the cause of inflation were wrong. And understanding the causes here is an essential part of understanding how to use policy to solve potential problems.

2) 2 myths that just won’t die.

I use Twitter as a real-time news source and research resource. If you curate a good feed, it's simply an unmatched resource for accessing intelligent, real-time views from financial experts. But sometimes it can be a hell of a place. For example, in the last few weeks I've seen several major Twitter accounts claiming that if you have a mortgage, the bank owns your house. Unfortunately, it seems to be an intuitive narrative that if the bank can kick you out of your house for not paying your mortgage, it “owns” the house in some sort of indirect way. But this is incredibly misleading.

I'm sure the smart readers know this, but accounting and legalities are very specific, and we should be absolutely clear that the bank does not own the house. They own the house as the title says they do. If you have a mortgage, you also own a liability equal to the amount of the mortgage. You sign a promissory note to pay $X over a period of time. That promissory note is a claim on the asset. The balance is equity that belongs solely to you because you are the owner. The bank does not participate in the upside or downside movement of the asset price change because it does not own the asset. It has a (usually) fixed claim on the asset. The “ownership” of an asset is directly tied to the equity interest. If you do not own an equity interest in an asset, then you do not own that asset.^2.

To put this in numbers, imagine someone owns a home worth $100 and has a $50 mortgage on that home. They own the $100 home asset and the bank owns the $50 mortgage asset. The net equity value of the homeowner's assets and liabilities is $50. Importantly, if the home's value increases to $200, the homeowner alone makes the $100 net gain because they are the owner.

As long as you pay your mortgage, the house is yours alone. And as with anything you try to buy, you'll find that if you don't pay, you don't own the thing. The bank has the right to enforce that promissory note, and that could result in foreclosure on your house. Again, if you don't pay for things, you don't own them. Anyway, I was surprised at how widespread the confusion was on this issue, so I hope this clears things up a bit.

In response to one of my comments on Twitter, someone posted a second myth that was unrelated but also widely circulated. This is a chart you may have seen on panic-mongering websites before. The image is meant to portray inflation as some sort of catastrophic situation where our “needs of life” have become prohibitively expensive. I've written a lot about this over the last 10 years and it's counterintuitive, but charts like this are not a sign of declining living standards and actually underscore how good our living standards are becoming. Let me explain.

100 years ago, things like college and healthcare were considered luxuries. Things like housing, clothing, and food were the main “necessities.” But as our standard of living improved, clothing and food became a smaller and smaller portion of our disposable income. As our standard of living improved, more and more things became “necessities.” The fact that college and healthcare are now considered “necessities” is a good thing because it's a sign that our standard of living is improving as these luxuries become more affordable to everyone. But it's also not surprising that these things are the fastest to rise in price. This is just basic economics and the graph here reflects a nearly perfect demand curve with rising standards of living, where things that were once luxuries become necessities. And as demand for these things increases, their prices will rise faster than others. So this graph doesn't show a declining standard of living. It shows a rising standard of living!

Don't get me wrong – I'm not downplaying the very real inflation and cost burdens these things impose on people. I'm just pointing out that these developments are part of progress. We should expect luxuries that become necessities to become much more expensive during this transition period.

3) The Powell pivot.

Well, Powell made it official on Friday in Jackson Hole – the Fed is cutting in September. Now the question will be how much will they cut rates (25 or 50 basis points), how often and for how long? I estimate they will cut by 25 basis points each of the next three meetings (September, November and December). But the more important point is that there is now a clear change in direction in monetary policy. The question is: how long will this change in direction last and how far will they go?

It is Away It's too early to guess, but I think the Fed wants to cut rates back to the 2-3% range. That's a point where savers can get an inflation-protected return and key benchmark rates like mortgage rates become somewhat affordable for consumers. So we're talking about 8-12 rate cuts, depending on how deep they are. In a “soft landing” scenario, that would take several years. The outlier risk is that the Fed lags and ends up having to cut very quickly to get us to 2-3% in even faster succession. So I would say we're now in the early stages of a multi-year rate cutting cycle, with the outlier risk that the Fed lags and ends up having to cut rates much faster.

Interestingly, we don't really know if they are “pivoting” or going backwards here. I've mentioned in the past that a pivot is a controlled movement on the way to the basket, while a backing up is a turnover where they are forced to go backwards after a mistake. We don't know for sure if they have been too restrictive for too long or if this remains a controlled “soft landing.” Time will tell.

NB – Speaking of inflation, check out my hedge against pumpkin inflation. I love growing pumpkins for Halloween, especially because my girls love checking the daily pumpkin progress. But I also laugh at the idea that growing your own vegetables is an inflation hedge. I can't tell you how many hours or dollars I've actually spent growing pumpkins knowing they'll only cost $5 in October. But it's not the end result that makes the progress so valuable to me. It's the journey of growing pumpkins that's so much fun. There's a cheesy metaphor for life in there somewhere.

1 – I have sometimes said that inflation would eventually appear “transitory,” in the sense that the inflation rate would eventually fall. That is not what the original users of that term meant, and I think some people have forgotten that the original premise for the transitory narrative was that inflation was a supply-side event that did not require a policy response. That is, after all, a big part of why the Fed was late to the party, and its abandonment of that narrative was also why it eventually raised rates so aggressively.

2 – When someone has a claim on another person's property, they don't necessarily “own” that thing. For example, if you have deposits in a bank, the deposit is your asset and the bank's liability. You have a claim against the bank and they are obliged to pay you the money. But you wouldn't go around telling people you own the bank because you have a claim against the bank. It's basically the same with a mortgage. They have a claim on your property, but that doesn't mean they own that property.

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Editor’s note: The summary points for this article were selected by the editors of Seeking Alpha.