In this latest discussion, Dr. Peter Linneman argues that interest rates remain too high relative to inflation, which has dropped significantly despite the Fed’s delayed reaction. He contends that the historical linkage between interest rates and inflation is effectively broken and explains that as short-term rates eventually fall, capital will rotate out of cash and into longer-term treasuries, likely driving the 10-year yield below 4% by early next year. Addressing the "human element" of the Board, Linneman welcomes the return of dissent among governors as a healthy corrective to the dangerous "groupthink" that characterized the previous decade. He suggests the modest size of the recent cut was likely influenced by this human desire for independence, as the Fed sought to avoid appearing swayed by political pressure.

The conversation also challenges the conventional wisdom regarding household formation, specifically the statistic that nearly one in three young adults is currently living with parents. While often cited as a "reservoir" of pent-up housing demand, Linneman challenges this optimism, categorizing the shift as potentially a structural "new normal" rather than a temporary cyclical delay. Citing factors such as reduced social stigma, the significantly improved quality of parental homes, and smaller family sizes, he argues the U.S. is trending toward European co-living models. Consequently, investors should view these elevated numbers as a permanent baseline—potentially settling around 30-35% for men—rather than a catalyst for a near-term boom in household formation.

Adam:

So jumping in, the Fed announced the 25 basis point cut. I think there was more to that news to digest in the story: It was described as the most divided vote since 2019. Does that dissent really matter historically?

Peter:

Okay, so the Fed finally did what they should have done a year ago. The interest rate is still 25 basis points too high relative to inflation. You could even argue 50 basis points too high. Anybody who's followed me knows I said this way before Trump was elected. So this has nothing to do with Trump. This is basic economics to me.

Inflation has come down like 700 basis points. And until the last couple of months, they had lowered the interest rates by 150 or 200 basis points.

I think they would have cut by this amount with little dissent had Trump never said anything. I can't prove that, but just think of the human part. Imagine the three of us are on the Fed. And what do we value more than anything? Our independence. You could argue whether we should have our independence or not, but they value that more than anything. Okay? And you've got a president very visibly screaming and trying to throw one of your members off and muttering that maybe the court will uphold him if he gets rid of all of them except the local presidents.

And the morning of your vote in October, literally the morning of the vote, a new member shows up and says, 50 bps. What are you going to say as a human being? You're going to say anything but 50 bps.

And I think had none of that happened, the circumstances would have been 50 bps. We were in a murky economy. We didn't have data coming out. You didn't quite know where we at. What's the harm? You can always raise it 25. They weren't going to meet in November. They knew that. And I think they basically gave the finger to the president.

Of course, I can't prove that. But it makes intuitive sense.

Now let's go to the dissents. You two guys are partners. Do you dissent sometimes? Of course, it's healthy. It's a good thing. There are a lot of complicated decisions and I wrote a piece about two years ago saying the lack of dissent in something like this is troublesome, it really is troublesome. This isn't easy. There's no layup.

If there's no dissent, it really bothers me. I could be on one side or the other but dissent is helpful. Otherwise, it's groupthink. And groupthink is dangerous. And in fact, for several years, they did groupthink. They did groupthink all through the 2010s when they kept the interest rate at basically zero. They had almost no dissent.

Now you talk about impacts, okay? They're claiming they're terribly worried about a 25 bps cut because it might possibly spark inflation. First of all, as they've lowered the interest rate you've seen no notable change in inflation. It's come down for other reasons, right? So the empiricist in you remembers that for the entire 2010s the interest rate was zero and go look at what inflation was: one to two percent.

The linkage that historically existed, and I mean historically, a long time ago, like when I was a graduate student a half a century ago, between interest rates and inflation, gone. Otherwise, how do you explain having the rate at zero for the 2010s and not having runaway inflation even as the economy grew? They're completely ignoring that evidence.

So they don't control inflation. That doesn't mean it doesn't have an effect. The interest rate has an effect. For example, you're a developer, you have a floating rate loan, every time they cut, your next payment is going to go down. You have a floating rate loan on your industrial property, it's going to go down. And your cash flow is going to improve commensurately. So that's one effect.

Second, auto. Auto is very sensitive to interest rate changes because two-thirds of all auto purchasers borrow on a short rate basis. And auto is way under-consumed, starting with the pandemic because we couldn't buy cars then they couldn't make them and then they didn't have parts and then they jacked up the interest rate.

But the most notable effect is something else. If you look at a five-year treasury and a 10-year treasury, the credit risk is the same as a short-term, 20-day, 30-day. The market determines the five-year, the seven-year, the 10-year, but the Fed determines the short-term rate. And maybe they determine it too high, too low, but whatever they do is it.

If you think about what happens if they had the short-term interest rate way too high. You could get as an investor, a really good return doing nothing, sitting on your hands. I don't even have to go out to a five-year or 10-year to pick up a few more basis points. So how does the five-year treasury and the 10-year treasury compete?

With a too high short-term interest rate, they have to lower their price, which is raising the yield. What happens then when that short-term rate comes down? The short gets less attractive and money rotates into long, bids up the price of long, and lowers the yields. And that's what everything then prices off.

Okay, so when will real estate people feel that? They're not going to feel it tomorrow. They're going to feel it over the next month or two.

Adam:

So the fact that there's been 150 basis points, yet very little movement in the treasuries, 5 and 10 year maturity because it hasn't quite been enough yet to get that money to rotate out?

Peter:

It's still an abnormally high return, not as abnormally, but still abnormally. So it's true that the Fed doesn't set the three year, the five year, the 10 year, but they massively influence it. And there's a lot of other things going on all the time. So I expect when we chat, let's say around February, you're going to have 10 year yield below four percent. I wouldn't be surprised if it's down to the 3.8 range. What's keeping it high is people aren't sure what the Fed is still going to do. Are they going to lower it? Are they going to change their mind and raise it back up? They are still trying to figure out what it all means.

Dan:

I have assumed that the Board of Governors were really at the top of their field and acting independently, potentially coming to different perspectives on the same set of facts like any group of people will. But the way you're describing it, I am surprised by how influenced maybe they are by political and other, call it more human, emotional even, factors. And you see that as being a material part of their deliberations?

Peter:

They were human before they were Fed members and they're humans after they're Fed members. And in a way, it's no different than the Supreme Court historically, right? These are hard decisions. I'm not saying any particular decision, right? Anything that makes it to the Supreme Court must have some level of “it's a hard call.” That's why you usually get some dissent. Does some of it reflect personal and political biases. Yes, but that doesn't mean they're not legit; it doesn't mean they're hacks.

Adam:

I read that somebody called it a hawkish rate cut, which was this intentional oxymoron to say hey, we're going to ease nominally, but the bar for more cuts is now higher, which scares me a little bit.

Peter:

Yes, but to be fair, every cut has gotten them closer to where they should have been months and months ago. It's not a surprise that the more they've lowered rates, the more disagreement exists. It gets to be a closer call. And so I don't view it as bad.

Adam:

Let’s pivot with the time we have. Something that I read last week: CNBC highlighted that nearly one in three 18-to-34 year olds are living at home and it's the highest since the Great Recession or dang near that. What do you think is a normal number therein a healthy economy?

Peter:

It's changed dramatically over the last 20 years, over the last generation. Part of it is cyclical and part of it is secular. When I was that age, you would be shamed if you were out of school and you lived at home. In the last 20 years, it's not a particular point of shame. Second, what happened is parents got much, much, much nicer homes over the last 50 years. If it's nicer than the crappy apartments you could have, of course you're going to be more attracted to remain at home.

Third is the decline in family size. If I've got six kids, I can't have them all coming back. But if I have one or two or three, I can have one without totally disrupting life.

All of these factors have gone on. It is mostly men. Your chart shows it.

And you can see in your chart that both men and women really tick up about 2001. It improved as the economy got a little better. Then it went up during COVID and I think it's a new norm. We've become Italy, except we have bigger homes.

So I can now come to your question, what's normal? I suspect for men 30 to 35% is going to be the new norm.

Dan:

Historically this population has been looked at as a reservoir of future demand because they would eventually leave their parents’ households and catalyze a lot of household formation. That's obviously a significant boost to the economy, and it has significant real estate implications.

And so we've been reading about how the higher this number gets of people living at home, the better it is - soon - as an economic growth driver. But you're saying, hey, maybe don't count on that because the new normal is for a higher percentage of these people to live at home for the reasons that you outlined.

Peter:

Yes, and in fact, if you really go back and look at the data, a funny thing happened. It shot up during COVID because a lot of people lost their jobs. And after COVID the number goes down really fast. And guess why? Some of those people did not want to live at home when they were home bound.. And then the world opened back up and it renormalized. And so my gut is we're just gonna see it for men in particular in the range of 30 to 35%, higher during a bad economy and at the lower end of that in a good economy.

Adam:

Dan, do you have any other nuggets that we wanted to pull out?

Dan:

Nope, this was great. I'm excited for the next one.

Peter:

I had fun.

Editor’s Note: At Stacked, We believe in sharing valuable information. If you enjoyed this week's conversation, subscribe for regular delivery and forward it to a friend or colleague who might find it useful. It's a quick and easy way to spread the word.