The Buck and the Bungalow
In Monopoly, another $200 enters the game whenever a player passes ‘Go’. Over time, the increasing money supply finds its way into property development. Something similar has played out in real life all over the world. Players have recycled a rising money supply into property. Now the game is suddenly getting tougher due to inflation.
Central banks printed enormous amounts of money during the pandemic, which they traded for bonds held on their balance sheets. The U.S. Federal Reserve’s balance sheet more than doubled from $4 trillion to over $8 trillion. The European Central Bank’s balance sheet nearly doubled to €8.5 trillion. The Bank of Japan’s balance sheet rose about 25%, which sounds moderate in comparison but is actually similar in magnitude because after many years of persistent debt monetization the BoJ’s balance sheet was, stupendously, about four times larger relative to GDP prior to the pandemic!
By trading dollars, euros, yen, etc. for bonds, central banks took uncertainty out of the system and suppressed yields. Before economies reopened, that new money largely sat there inert. Now it is escaping into the economy, and central bankers are faced with a difficult choice whether to increase interest rates and withdraw liquidity to combat inflation and preserve the value of their home currencies. Globally, the popular response so far has been to let inflation rip.
The U.S. Fed has been somewhat exceptional in acting against inflation, and the U.S. dollar has strengthened in response. The Fed started increasing short-term rates in March and has now walked rates up to 1.75%, with more increases expected. The Fed has also promised to reduce its balance sheet through bond sales and the natural runoff of maturing issues. The early progress on this front has been underwhelming. Four months into the announced reduction phase, the balance sheet has come down only about 1% from its peak. For context, the balance sheet is still up 12% from when Jerome Powell made his infamous “transitory” speech in June of 2021.
At least the Fed’s direction is clear. Meanwhile, I’m shocked at the continued dovishness of foreign central banks despite high rates of local inflation. Broadly speaking, measured inflation in Europe is about on par with what the U.S. has experienced, yet the European Central Bank has not made any balance sheet reductions and is still maintaining a negative interest rate! The ECB is expected to hike rates by 0.25% for the first time post pandemic in July to…just -0.25%. Yup, still negative. Japan’s central bank has behaved similarly, although it has the cover of lower measured local inflation. The simplest way to explain the dollar’s nearly 20% rise against the yen and 12% gain on the euro this year is that our central bank is the only one taking any substantive action to fight inflation. Why are other countries so blasé about letting prices rise while their currencies depreciate?
This contrast between a merely dovish U.S. Fed versus ultra-dovish Europe and Japan has been longstanding. U.S. bond yields, net of inflation went negative in 2011 according to data compiled by Bloomberg’s John Reade. Since that time, U.S. real yields have fluctuated in a range between -1% and +1%. The idea that bonds pay approximately nothing after inflation is a modern invention. The economic historian Paul Schmelzing has estimated that over the past 200 years real rates have averaged about 2.6% around the world, and in fact this was approximately the U.S. level during the decade before 2011. Something changed after the financial crisis. Long-term bond yields are affected by many forces beyond the control of central banks, but it certainly seems like U.S. monetary policy has been very dovish compared with historical norms.
Now look at European yields. According to data from MSCI, Euro area real yields diverged from U.S. yields in 2013 and became consistently negative, averaging about 1% less than U.S. real yields before the pandemic. That’s a level of interest rate suppression that puts the U.S. to shame.
What is going on? It occurs to me that housing is playing a sneaky role in driving central bank decision making and, in turn, suppressing interest rates. It is easy for stock investors to forget that many people’s only significant investment asset is the equity in their home. This has always been true and has only become truer over time. People own a lot more home than they used to. According to longtermtrends.net, the average house price in the U.S. recently reached 8 times median income. It averaged about half that for more than 30 years before the run up that anticipated the housing crisis of 2008-09. Some of the long-term increase is probably attributable to improved quality of housing. The median average new home is better today than what was normal in decades past, and is certainly much larger. That said, the recent increase is a little worrying because it has taken the market up to a level that exceeds pre-housing crisis highs. Whether current prices are justified or not, it is mechanically true that people’s houses are at the center of their financial universe, more than ever.
Europe is more worrisome. The best data I can find comes from the United Kingdom, which is no longer a member of the European Union but should be a reasonable proxy for the Euro area overall. In the U.K., home prices as a multiple of income never receded much after the housing bubble and have drifted up to nearly nine times annual median wages. I’m married to a Brit, and when we watch period dramas like Downton Abby or Poldark she often laughs at the supposedly modest cottages and mews that the poor live in. “That place would cost a million pounds today,” she says, “minimum.”
When interest rates go up, the mortgage on that million-pound cottage gets more expensive quickly. Mortgages in Britain have little to no protection against higher rates. Long-term fixed-rate mortgages are basically unheard of. Higher rates quickly necessitate higher payments. The U.S. is very unusual in offering long-term, fixed-rate mortgages.
I don’t have great data for Asian countries, but housing is famously expensive in Asia’s major cities. I do have data for Hong Kong, which is admittedly a special case but still stunning. Housing there goes for 20 times the median annual income!
With global consumers’ financial health more dependent than ever on the housing market, it makes sense why central bankers are reluctant to increase rates. They fear political blowback. In theory, central banks are supposed to be insulated from politics, but that isn’t how they act. Inflation may annoy voters, but a housing crisis would probably annoy them a lot more. The U.S. housing market is not as inflated compared to foreign markets, and the American dollar is currently rallying in large part because Americans are somewhat less housing obsessed compared with most of Europe and Asia. This gives the U.S. central bank more leeway to raise rates, and the dollar is benefitting. We’ve hardly been monetary hawks, but we haven’t treated the dollar like Monopoly money either.
Miles Putnam, CFA