Too Little, Too Late

August CPI Inflation was just 1.4% . Rates should be 3%, not 5%. By not reducing rates a year ago the Fed has shut down bank lending and damaged small businesses.

Summary: Today’s baby step by the Fed is too little, too late. Correcting the August CPI for Owners' Equivalent Rent (OER) bias reduces 12 the month inflation rate from 2.5% to just 1.4%. By not switching to lower rates a year ago, the Fed has damaged bank balance sheets and shut down bank loans. Small businesses and their employees are paying the price.

Corrected August Inflation 1.4%

As I have argued many times over the past 18 months, there is a fatal flaw in the composition of the “market basket” the Department of Labor uses to calculate the consumer price index. Although the CPI is typically described as a measure of out-of-pocket costs—as opposed to the PCE, a broader index that includes spending on behalf of households made by third parties—businesses, governments and nonprofit organizations—such as employer-paid health and life insurance and pension contributions.

As shown in the table above from the August CPI report, the All-items index increased by 2.5% over the preceding 12 months. “Rent of primary residence”, an appropriate measure of the housing costs for people who rent their residence from someone else increased by 5.2% during the year but makes up only 7.662% of the total index.

The problem is with “Owners’ equivalent rent of residences” (OER) shown in the bottom row because OER because OER is a made-up number that purports to measure the hypothetical amount that I , as a homeowner, would would have to pay every month to rent my own house from myself. OER, which accounts for a whopping 26.825% of the total index, increased by 5.4% over the year. The appropriate weight is zero.

Fortunately, it is an easy problem to fix. All we have to do it to use the numbers in the table to calculate how much the legitimate portion of the All items index (everything except for OER; I’ll call it CPIXOER) would have had to rise to make the appropriately weighted average of CPIXOER and OER equal to 2.5%. The result: in the 12 months ending in August CPIXOER increased by 1.4% far below the Fed’s 2% target.

Business Loans Have Flatlined

Small businesses depend on bank loans for the working capital they need to meet payroll and pay other costs before they get paid, in turn, by their customers. In normal times, lending decisions are based upon interest rates, fees, and credit quality of the customers, and bank loans grow in line with GDP. On occasion, however, something goes wrong with bank balance sheets, banks shut down lending, and we go through a period of non-price rationing. The newspapers call it a credit crunch.

As you can see in the chart, above, we have a baby credit crunch brewing today. After their wild ride during the COVID pandemic, business loans resumed their normal course until they flatlined in January, 2023, just before the Silicon Valley Bank bust.

In fact, the total outstanding stock of bank commercial and industrial loans ($2779 billion) today is $34 billion lower than it was in January, 2023 ($2813 billion). That means, over the past 20 months, banks have collected $34 billion more from their customers than they have loaned to their customers, not including payments for interest and fees!

The proximate cause of the flatlined business loans was the damage done to the values of the Treasury bonds and mortgage securities on regional bank balance sheets when the Fed jacked up interest rates to current levels.

As credit crunches go, this is a mild one so far. For comparison, during the Subprime Mortgage recession bank commercial and industrial loans fell by 20% ($401 billion) between October 2008 and October 2010. Where it goes from here will depend on what the Fed does with interest rates. If they quickly bring rates down, regional bank balance sheets will improve and banks will sooner or later start lending again. If the Fed continues to drag its feet, business loans will decline and the economy will deteriorate.

The monthly ADP employment reports are the best way to track the damage. I prefer the ADP report to the official BLS Employment Situation report for two reasons. First, the ADP report is published a few days earlier than the official report that everyone else agonizes over, giving me time to think things through before everyone else freaks out when they see the jobs number. Second, ADP measures actual paychecks paid by actual businesses to actual employees rather than self-reported answers to monthly surveys conducted by the Bureau of Labor Statistics. In August, ADP reported that private employers added only 99,000 employees, as shown in the chart above. Small businesses with 20-49 employees—the ones that depend on bank loans to meet payroll—reduced employment by 12,000 people.

How Low Can They Go?

So, how low does the Fed funds rate have to go to solve the problem and restore growth? While there is no precise answer, my gut tells me that money market yields would have to fall substantially, say from 5% to 3%, to repair the damage to bank balance sheets and make business loans broadly available again. How long it takes the Fed to get there will determine whether the economy grows or shrinks over the next 2 years.

Dr. John