Stock and Flow
The stock effects of monetary tightening are clearly disinflationary, but the flow effects are less clear. The Fed’s rapid tightening markedly reduced the level of household wealth and thus potential demand, but the bulk of asset repricing seems to be behind us. The impact of tighter policy going forward is less certain because higher rates restrain some sectors but subsidize others. Interest income from reserves, RRP, and newly issued Treasuries rise along with rate hikes and can potentially increase demand. In addition, households and corporations borrowed at historically low rates and have been largely insulated from recent hikes. This post walks through the cross currents of higher interest rates and suggests the relative ineffectiveness of the Fed’s policy tools may lead to a more aggressive policy response.
One of the Fed’s tools to impact aggregate demand is by adjusting household wealth, which in turn impacts household spending power. Changes in interest rates directly impact fixed income assets, which then flow through to the rest of the market. The wealth effect was an explicit rationale for QE, where higher asset prices were thought to boost consumer spending. By the same logic, lowering household wealth can potentially lower consumer spending and dampen inflation. However, growth and inflation remained subdued post-GFC even as asset prices leapt higher.
One reason for the ineffectiveness of the wealth effect could be the narrowness of its reach. Public data suggest that the top 20% of earners hold 70% of household wealth, so most households are unaffected by the wealth effect. Note there is uncertainty to this estimate as it does not include crypto, which may have a different investor profile. In a sense, a negative wealth effect is functionally a one-time progressive tax hike that may be too progressive. Consumer spending appears resilient even after large declines in asset prices, though most asset prices remain comfortably above pre-pandemic levels.
Higher interest rates can restrain economic activity by increasing the cost of credit, but the impacts have so far been limited. The dampening impact can arise from slowing the rate of credit growth and increasing the interest payments of current borrowers. Housing market activity has slowed significantly as mortgage rates rose, but the overall pace of credit creation remains clearly above pre-pandemic levels. Recent surveys indicates that banks expect credit demand to wane, so a broader slowdown in credit growth may eventually materialize.
Households and corporate interest rate expenses have largely been unaffected from the aggressive rise in interest rates. The bulk of U.S. household debt is in the form of 30-year fixed rate mortgages, which have largely been refinanced at generationally low mortgage rates. Corporations have the highest debt servicing capacity in 20 years as their revenues rose with inflation but interest expenses were little changed. Corporations borrowed heavily when rates were low and will eventually have to refinance at higher rates, but the overall maturity schedule for them indicates that is a few years away.
The economic impact of higher rates is mixed because it also subsidizes consumption by increasing private sector interest income from public sector liabilities. While private sector interest expenditures merely redistribute income among private actors, public sector interest rate expenditures are financed by printing money or Treasuries (which are money like). These payments increases the overall spending power of the private sector. Public sector interest expenditures include the interest the Fed pays on reserves and the RRP, as well as interest on the trillions in Treasury securities. If rates are higher for longer, the interest payments will easily exceed a $1t next year.
Note that one day the level of public sector liabilities may become so large that the interest income channel dominates other channels. That may make monetary policy obsolete, or paradoxically require lower rates to dampen inflation.
The aggressive rate hikes have thus far appear to have a limited effect on dampening inflation. Wages and nominal GDP are growing at around 6.5% and 9%, respectively, both rates that are very inconsistent with a 2% inflation target. Wage growth may be particularly resilient, as demographics suggest the working age population is no longer growing. With the policy rate much closer to the terminal rate than 0% and financial markets stabilizing, the stock effect of monetary policy appears to be waning. If the flow effects are mixed, then the current stance of policy may not be effective in moving inflation back to 2%. This may prompt the Fed to bang harder on the only button they have.