As the Federal Reserve pauses its run of interest rate hikes, we identify four key factors behind the longer-than-expected lags in the effects of monetary policy being felt in the economy.
After raising rates for ten consecutive meetings, the Federal Reserve (Fed) bucked the trend at its June meeting and left interest rates unchanged. Signals from Fed members meant this was already expected, with the market looking for a “skip then hike” for the June and July meetings.
However, the accompanying statement and economic projections following the meeting made it clear that this was likely to be a temporary pause and not a signal of a pivot to lower interest rates. The “dot plot” of interest rate projections showed that the median expectation amongst members was for two more quarter-point increases in the federal funds rate with no cuts this year. Chair Powell’s press conference reinforced the point that another rate increase was being teed up for next month’s meeting.
The decision not to hike this month was largely driven by the desire to monitor the impact of policy tightening to date. As Milton Friedman famously said, interest rates work with long and variable lags. Judging those lags is proving particularly difficult this time around as evidenced by the large number of forecasters who had expected the economy to fall into recession and have had to revise their views. After a strong start to the year, many are now raising their growth forecasts for 2023 and pushing out a recession to the end of this year, or beyond.
Being amongst those who have had to acknowledge the resilience of the US economy and have upgraded our US growth forecasts (see our recent Economic and Strategy Viewpoint here), we have been examining this policy cycle to assess whether it really is different this time. The US economy has surprised with its strength in the face of Fed action and we identify four key factors which help explain why the lags from policy appear to be taking longer than expected.
The first-rate rise came on 16 March last year when the US central bank raised the target range for the Fed funds rate from 0 to 0.25%, up to 0.25 to 0.5%. Rates had been held at close to zero for nearly two years having been slashed in response to the pandemic. Thereafter rates did rise sharply to their current range of 5 to 5.25%; however, they remained below inflation throughout and arguably only became restrictive in real terms toward the end of last year (chart 1).
Chart 1. US rates versus core CPI inflation
Source: Refinitiv, Schroder Economics Group, June 13th, 2023
Although this has often been described as an aggressive hiking cycle as measured by the speed with which rates have risen, given the low starting point it has taken some time to get rates to a level where they can be considered restrictive. Consequently, the time taken from the first rate rise to when it has been able to impact the economy has been extended.
In the initial stages of tightening, Treasury bond yields rose sharply as the market adjusted to the end of emergency policy. This transmitted policy to other parts of the economy such as mortgages and credit markets resulting in a broader tightening of monetary conditions. However, in September last year, bond yields stabilized at just below 4% and have been there ever since. Mortgage rates subsequently leveled out and although they remain at their highest levels for more than a decade the pressure on housing has not increased further (chart 2). Meanwhile, equity markets have rallied with the S&P 500 index rising by just over 20% since the end of September (as of 14 June). Although the advance has been largely confined to a handful of tech stocks, the effect has been a loosening of financial conditions.
Chart 2. Fed funds and financial conditions (selected bond yields)
Source: Refinitiv, Schroder Economics Group, 13 June 2023.
Both President Trump and his successor Joe Biden injected significant stimulus into the economy through direct pay-outs and through enhancing benefits. These helped support families as firms laid off workers and unemployment surged. Using figures from the IMF which strip out cyclical effects, we estimate the fiscal support to have been worth around 5% of GDP in 2020. Although it is hard to be certain, some of the stimulus remained in the system through multiplier effects, or as latent demand in the form of savings. This provided important relief, but may well have contributed to inflation by boosting demand, making the Fed’s job harder in reining in expenditure. At the time some commentators argued that such fiscal largesse would create inflation and it would seem that such predictions have proved accurate.
In a similar vein, households have gained support from the excess savings which they built up during the lockdown period of the pandemic. Unable to go out and spend, but still earn income through working from home, people built their savings above normal levels. These excess savings have provided important support to consumption as the economy re-opened, particularly in the face of higher inflation. Consequently, consumption has remained resilient even during high inflation and falling real income.
Chart 3. Excess savings and drawdowns
*Personal savings have been de-annualized. The pre-pandemic trend is calculated using the 48 months of data prior to the 2020 recession.
Source: Schroders Economics Group, Bureau of Labor Statistics, Refinitiv. 9 June 2023.
While we had anticipated such an effect, judging the strength and duration has proven difficult. Data on the distribution of excess spending is only available with long lags, making it hard to determine the propensity to spend. There have been few if any comparable periods on which to calibrate the scale and duration of the boost to spending.
Closely related to this effect has been the skew imparted on goods and services consumption by the pandemic. As mentioned above, during the lockdown household spending was focused on goods that could be bought on the internet and delivered to home. With human interaction limited, services such as hotels, restaurants, and travel were restricted or shut down. Sales of goods ran ahead of the trend while services languished. As the economy reopened the latter recovered and goods sales fell back. Today it is noticeable that surveys such as the Purchasing Managers show the service sector outperforming goods as people rediscover the joys of travel and find they already have enough gym equipment, electronics, and other such lockdown paraphernalia.
Consequently, the pandemic had two effects on the consumer. First, it made the consumer more resilient and, second, it skewed spending. Some have described this as creating a rolling recession where first services and then manufacturing went into recession. It has also meant that leading indicators and recession warning models which are very dominated by the more cyclical goods sector have tended to be too bearish by sending signals which are too negative for the economy as a whole. The service sector has become uncorrelated with the goods sector. Given their relative size (services account for just under 60% of household spending compared to goods at 21%) the recovery in services has offset the recession in goods manufacturing.
The rebalancing of consumer spending probably has further to run. Analysis by the San Francisco Fed suggests that much of the excess savings have now been spent, indicating that this effect on consumption will gradually fade. So far some $1.7trn of the excess has been spent out of a total of $2.1bn excess savings. Nonetheless, this still leaves households with some $400bn worth of potential spending (equivalent to around 2% of consumption) so the effect will be gradual.
The second pandemic effect is on the supply side where labor markets have been affected by a combination of early retirement, a return to college, and illness (long Covid and long waiting times in getting treatment at hospitals trying to clear backlogs). Although there has been a boost for some groups of workers who find it easier to work remotely, the overall effect has been a fall in the number of people in the labor force and a decline in the participation ratio.
As a consequence, the pressure on wages has been greater than anticipated as shortages have emerged more rapidly. There are some signs that participation rates are picking up which may reflect the return of immigration and a reversal of some of these factors. Overall though the pandemic has skewed the balance of supply and demand in an adverse direction, exacerbating inflationary pressure.
Of these four effects, the low starting point for rates, fiscal largesse, and the pandemic effects have been most unique in making it harder for the Fed and other central banks to interpret and then tame the economy and inflation.
The monetary policy started from an ultra-loose level and while the Fed and others might have realized the need to tighten sooner, this came against a very uncertain backdrop of the ongoing pandemic. In addition, they had to offset the stimulus from the fiscal policy as well as contend with the unusual effects of Covid on spending and the labor market.
Notwithstanding the support from the Inflation Reduction Act and the excitement over AI, our view is that the tide will begin to turn in favor of the Fed as we go forward. Monetary policy is now in restrictive territory and the benefits of fiscal support and excess savings are diminishing.
The offsetting behavior of financial markets is also important, although is not unique to this cycle. For example, in 2005 when the Fed raised rates by 150 basis points with little impact on 10-year bond yields – known at the time as the “Greenspan conundrum” – there was much talk of the Fed losing control over monetary policy.
In this cycle, the Fed may still have to do more to convince the bond markets that it is determined to beat inflation and no doubt accounts for the hawkish tone at its latest meeting.