Since the Fed began raising interest rates a year ago this month, the central bank has moved more aggressively than almost anyone expected at the time. It has raised target rates by 4.5 percentage points, with more to come, and shrunk its balance sheet by more than $600 billion.
- But the economy remains as robust as ever with unemployment at a five-decade low and inflation still well above the Fed’s target.
Why it’s important: Something strange happens when the Fed can tighten so much to obtain the little in terms of reducing demand—and that raises important questions about the Fed’s ability to achieve its assigned price stability goals.
- It is the mirror image of the situation from the 2010s, when extraordinary monetary stimulus could never gain enough traction to promote more robust demand and higher inflation.
Status: There is little doubt that the Fed’s actions have affected financial markets, given last year’s sharp decline in the stock market and higher interest rates on corporate bonds and mortgages.
- And in a few sectors, mainly housing and technology, you can see signs of the tighter economic conditions flowing through to layoffs and less activity.
- But across the broad swath of the economy, there is no luck as consumer demand and overall employment have remained unusually healthy.
What they say: When Axios asked Chairman Jerome Powell about the narrow economic response to higher interest rates at a news conference in November, the Fed chief emphasized the strength of the labor market and consumer balance sheets going into this period.
- “We’re going into this with a strong labor market and excessive labor market demand … and also with households having strong purchasing power built up,” Powell said. “So it may take time, it may take determination, it may take patience.”
But: The fact that four months later there is precious little sign of a meaningful slowdown, and the fact that interest rate policy seemed to have hit nothing in the last economic cycle (albeit in the other direction) leads us to believe that something else on the way.
- In fact, research conducted in that era pointed to long, slow-moving trends that caused interest rate movements to have less impact than in the past.
Retrospective: A 2015 paper by Jonathan L. Willis and Guangye Cao of the (then) Kansas City Fed explored many potential factors.
- The paper looks at how structural changes in how companies operate – such as just-in-time inventories that reduce the need for working capital – may have reduced their sensitivity to interest rates.
- Furthermore, changes in short-term interest rates set by Fed policymakers do not flow through to long-term interest rates, which influence economic decision-making as much as in the past.
- That’s especially evident right now, with 10-year Treasury yields a full percentage point lower than the six-month rate — meaning long-term borrowing costs for businesses and homebuyers are still quite low by historical standards despite the Fed’s tightening.
separately, a 2010 paper by Jean Boivin, Michael T. Kiley, and Frederic S. Mishkin notes (among other things) changes in the structure of the banking industry may be a factor.
- In the old days, tighter money from the Fed not only meant higher borrowing costs, but often meant that banks faced a shortage of funds to lend, so they would tighten lending and throttle credit in the economy.
We will offer another theory it is more speculative. An important channel through which monetary policy affects the economy is the wealth effect – when asset prices rise, people spend more, and when they fall, they spend less.
Let’s imagine a stylized example. In a hypothetical country, there are 1,000 people who each have a net worth of $100,000. If the value of their portfolio falls by 20% due to tighter monetary policy, they would probably all cut back on their spending.
- But in a country where 999 people have zero net worth but one person is worth $100 million, the effect would likely be different. Falling asset values wouldn’t affect the 999 poor people, and the one rich person is so rich that they probably wouldn’t cut their spending either.
Between the lines: Clearly, the United States is not as radically unequal as the hypothetical. Meanwhile, consider this: Jeff Bezos’ net worth has fallen 35% over the past year, according to the Bloomberg Billionaires Index, shaving $61 billion off his net worth.
- Fed policy is a major factor in this decline.
- But considering he’s still worth $116 billion, do you think he’s cut back on his spending as a result? We don’t do that.