US rates have been above 5 per cent for nearly a year. And yet . . . services inflation is kind of high, the labour market remains strong, and financial markets seem to reflect no worry whatsoever.
Is this how The Economy is supposed to work?
Dario Perkins, TS Lombard global macro strategist and noted former gold BMW owner, tackles that question in a note today:
Higher interest rates have proved a lot less destructive than investors feared in 2022, when the world’s central banks embarked on one of the most aggressive episodes of monetary tightening in history. Nothing has “broken”, contrary to the prevailing view two years ago; and this has even sparked a lively debate about why mainstream macro exaggerated the dangers of higher rates.
Central bankers have long argued that changes in interest rates affect global economies with “long and variable lags”.
So the continued strength in markets (including labour markets) doesn’t necessarily conflict with orthodox views of monetary policy. Nor does it mean that the Fed’s current monetary policy won’t ever affect the broader US economy. It might just be taking a while, for whatever reason.
But the issue is still important, Perkins writes:
With monetary policy at a critical juncture, the evolving judgements central bankers make about the appropriateness of their policy stance will have powerful implications for how financial markets — and the global economy — perform in 2024/25. We provide a detailed assessment of the “monetary transmission mechanism”, together with markers that will help investors to navigate the current uncertainties.
That’s because there are a few other possible explanations for the lack of any significant economic slowdown.
One of them — certainly the funniest — is that monetary policy just doesn’t affect the global economy as much as we think, or the way that we think.
But it’s tough to give too much credence this idea, especially for the US, where interest rates obviously affect mortgages, credit cards, car loans, consumer sentiment, and lots of other important things. Perkins and his colleagues don’t buy into that line of thinking either. But again, it’s very funny.
Instead Perkins argues that all of the obvious effects can fit into one of two “transmission channels”, where Fed policy can have clear and direct effects on economic growth.
The first is the “intertemporal substitution” channel, he says, which covers the factors that drive people’s decisions over whether to borrow money or save it.
It might sound complicated, but it has been very obvious that Americans are changing their decisions about borrowing and saving! Financing the purchase of a new home or car is a much bigger burden now than it was five years ago. And returns on cash are much higher than normal, so investors spent last year crowding into money-market funds instead of YOLOing into risky markets (notwithstanding the recent crypto rally).
The other channel is “income effects”. Higher Fed rates are supposed to boost income to lenders and reduce the income of borrowers. While these two dynamics could balance out, there’s pretty strong evidence that borrowers have a higher propensity to spend, and lenders have a higher propensity to save. (This is why the neo-Fisherian theory that higher rates boosts inflation doesn’t really work, as Perkins points out.)
The broad “income effect” — less spending and more saving — normally works to slow economic growth by reducing spending and profit for businesses, which then translates into a decline in hiring and investment.
But real incomes held up pretty well for households last year:
This is partly because many US businesses and consumers rushed to lock in low long-term fixed interest rates in 2020 and 2021, when rates were near zero. So those businesses haven’t needed to cut jobs or investment just to manage their cost of debt.
Government policy can also explain the resilient incomes — and that’s not just Covid relief, but policy moves that came after. From Perkins:
The obvious one is fiscal policy, with governments everywhere using budgetary stimulus more actively since the pandemic. The impact of higher interest rates has been dampened in two ways. First, consumers had high levels of liquid assets (sometimes called “excess savings”) left over from the pandemic, which provided a financial cushion that protected their spending power. Second, governments have been deploying additional funds since COVID-19, such as the large energy support programmes in Europe and Bidenomics in the US (big tax subsidies that encouraged US companies to invest heavily in green energies). These funds have supported incomes and employment, even as monetary policy engineered a squeeze.
It’s tough to tell just how much support fiscal policy has given the global economy, however, because data in general has been puzzling since Covid-19 relief, he adds.
All of this means that the US economy (and global economy) could still be due for a recession driven by lay-offs and falling incomes at current interest rates.
If the explanation is really that Fed policy is working but with a long lag, Perkins lists some “monetary canaries” that could show US policy is actually hurting growth. He’ll be watching residential property markets in Australia, Canada, the UK and Sweden; commercial real estate in the US and Germany; US corporate debt; and default rates from US consumers on credit cards and auto loans.
Alternately, more economic strength could convince central bankers they need to raise rates further because R* is actually higher after Covid-19. This would also be very funny, though not in a “ha ha” way:
The only scenario that might convince central banks that r* has increased is one in which the global economy is reaccelerating and this leads to a renewed tightening in labour markets. Rightly or wrongly, central banks believe higher interest rates have helped to address a fundamental imbalance in their economies by reducing labour demand relative to supply.
If labour demand started to pick up again, owing either to faster employment growth or to a rebound in job vacancies, they might conclude that monetary policy is not as restrictive as it seemed. Although this scenario does not seem very likely and the hurdle for rate hikes remains high, the lesson of the past few years is not to take anything for granted. This is no ordinary business cycle.
In other words, global central bankers might need to make a judgment call about a highly uncertain theoretical construct that’s basically useless in real-time policy decisions, based on the economic results of five years of highly unusual monetary and fiscal policies. What could go wrong?
