In an April column, The U.S. May Be in a Liquidity Trap, I discussed the potential for the U.S. to be caught in a deflationary process rendering traditional countercyclical monetary stimulus incapable of stopping the process from concluding. That process involves all excess debt and asset inflation created by the previous bubble in them to have to be completely unwound and absorbed before a secular reflationary process in debt, assets, income, and production may begin.
In this column, I'll expand on the issues raised earlier by focusing on a phenomenon that is very troublesome for monetary authorities and policy. The single biggest component of inflation, whether it is determined by the consumer price index (CPI), or by the personal consumption expenditures (PCE), is that the largest component of each is the cost of housing. A brief primer on CPI and PCE may be found here.
Housing costs for each are not computed as a measure of home price appreciation, or by carry costs for mortgage debt. They are calculated as owner's equivalent rent or actual rental rates.
The most important aspect of this with respect to monetary policy, the housing sector, and the economy overall, is that rents have been increasing in real terms ever since the housing crash and financial crisis of 2008. Zillow (Z) commented on the rising rents situation in its Real Estate Market Report for July, released on Aug. 20, in which the company noted:
Rental affordability is currently much worse than mortgage affordability, largely because rents didn't experience the huge drop seen in home values during the recession, and instead have just kept their upward trajectory. Nationally, renters signing a lease at the end of the second quarter paid 29.5 percent of their income to rent, compared to 24.9 percent in the pre-bubble period.
In addition to rising rents, Zillow also noted that during the same time period in which rents increased, the amount of income qualifying borrowers were allocating to mortgage carry costs declined from 22.1% to 15.3%. This was due to lower mortgage rates. The key word here is qualifying.
Even as the Fed has been holding mortgage rates down, its efforts at stimulating a broad-based recovery in housing activity have been counteracted by a legislative mandate making access to mortgages more difficult and by lenders' reluctance to lend. This has created an environment in which those with equity capital and/or access to debt capital have been able to capitalize. Meanwhile, those without either have not just been left unable to purchase but have also experienced increases in their housing costs.
This is putting upward pressure on the CPI and PCE but that is being counteracted by reductions in other components of inflation as an increasing percentage of disposable income is being allocated toward housing and leaving a dearth of discretionary income to be allocated to other areas of the economy for consumption.
This is not just an unintended consequence of the monetary stimulus of the past five years, it is the exact opposite of what it was supposed to produce. The countercyclical monetary stimulus response has actually produced a procyclical response by the markets. This is exacerbating the wealth and income disparities that were already evident in the economy prior to the crisis.
This delineation is largely along demographic lines and is leading toward a bifurcated economy of haves and have-nots with the senior X generation and Baby Boomers gaining from the stimulus while the juniors in the X generation and millennials are falling further behind. As her very balanced presentation at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming last week made clear, Fed Chair Janet Yellen appears to be very much aware of this situation and the negative implications for future economic growth.
Compounding this drag on the economy is the fact that the beneficiaries of the stimulus are at or beyond their peak spending years while the generations behind them, whose consumption is necessary for economic activity to increase, are being negatively impacted by the stimulus.
Further, the beneficiaries are not only in their waning consumption years but will increasingly become the recipients of fiscal transfers by way of Social Security and Medicare. These outlays will make providing fiscal stimulus targeted at the younger generations more difficult as well.
From an investor's perspective, the sectors of the equity market most at risk from a continuation of this trend are the retailers who cater to the discretionary income of all consumers -- but mostly those in the 25-34 year-old demographic. In tomorrow's column, I'll discuss some of those sectors and companies.