Can Financial Conditions Be Fine-Tuned?

Summary

• A bottom-up assessment of monetary policy transmission suggests policy fine-tuning would be difficult.
• Residential investment is the demand component most responsive to funding costs but accounts for only 3.5% of GDP.
• The Fed impacts consumption, which accounts for 70% of GDP, mainly through equity and home prices rather than through funding costs.
• Non-residential investment (‘capex’) is much more responsive to the output gap than to funding costs.
• Should inflation prove sticky, targeting below-trend growth would be difficult to implement precisely and could carry large economic, financial and political costs.
• This suggests inflation must accelerate substantially before the Fed considers it.

Market Implications

• I still expect the Fed to cut twice in 2024 in line with market pricing 1.9 cuts, down from 2.7 cuts before the NFP.
• Longer term, the Fed may have to revise its easing plans, though this revision would be unlikely before the 5 November elections.

A Bottom-Up Assessment of Monetary Policy Transmission

Here, I examine the transmission of monetary policy to the real economy. I use a bottom-up approach to analyse the response of demand components to the monetary policy cycle (Table 1).

My main conclusion is that US growth could not be brought below potential without a marked decline in equities and home values. The economic, financial and political costs would be so high that the Fed would rather tolerate above-target inflation than engineer the recession necessary to return it to target.

Residential Recovery Could Be limited By Mortgage Lock-in

The most interest rate sensitive component of demand is residential investment (Chart 1).

The Fed plans 150bp in cuts between now and end-2025, which will lower mortgage rates. However, Fed easing could fuel home price inflation more than residential investment.

Housing affordability is already worse than even the pre-GFC lows (Chart 2). Lower mortgage rates may have little impact on supply of existing properties for sale due to the mortgage lock-in effect. About 60% of current borrowers pay 4% or less on their mortgage, compared with current mortgage of 6.3% for the benchmark 30-year fixed.

The decline in market mortgage rates would have to be large enough to induce existing homeowners to put their property on the market, thereby increasing the inventory of home available for sale. Failing that, there is a risk that lower mortgage rates would further increase home price inflation and weaken affordability and, eventually, demand.

Faster home price inflation would, however, support consumption.

Fed Easing to Support Consumption Through Wealth Effect

Compared with residential investment, consumption is less volatile and less responsive to borrowing costs. Consumption and interest rates seem jointly driven by expansions/recessions rather than the latter driving the former (Chart 3).

In addition, during the pandemic, fiscal policy was the main driver of consumption. Unprecedented government transfers saw an unprecedented surge in consumption: in 2021, consumption contributed 5.2ppt to GDP growth of 5.7%. Durables consumption was also exceptionally high.

One would have expected a contraction to follow this binge. After all, how many phones, TV sets, appliances etc can one consume? Strikingly, this was not the case: since end-2021, consumption growth has averaged 2.3% annualized, lower than 2.6% average in the three years before the pandemic but still in line with trend GDP growth of about 2%. This resiliency could partly reflect the surge in immigration of 2022-23.

We can also see the FFR’s limited impact on consumption by plotting the household saving rate against the FFR (Chart 4). There is no obvious relationship.

Rather, up to the GFC, the secular decline in the household savings rate seems to have been driven by an uptrend in household wealth. Following the loss of wealth associated with the GFC, household savings increased markedly. Since the pandemic, a large increase in wealth, together with the higher cost of necessities, could explain the lower savings rate.

This suggests Fed influence on consumption is indirect, through a wealth effect, namely through its impact on equity and home valuations that on average account for half of household wealth (Table 2). Note that bonds, which are included in FCIs, account for only 3% of household wealth.

For all the tightening implemented during 2022-23, both home and equity prices increased, sharply in the case of equities (Chart 5). The wealth increase was largest for those at the top of the distribution due to their larger holdings of equities (Chart 5).

Increased asset value has driven the rise in household wealth since the pandemic. Liabilities fell relative to income with household credit growth below historical averages (Chart 7).

This makes the recent weakening of household credit quality puzzling (Chart 8). This partly reflects normalization from a period of blanket credit guarantees and regulatory forbearance (that is about to expire for student loans).

But increases in car loans and credit-card delinquencies above pre-pandemic levels do not seem consistent with strong household balance sheets and very low unemployment. Rising delinquencies could reflect poor lending practices. I intend to explore this in future research.

Ahead, the Fed forecast of a soft landing is positive for equities and home prices, and therefore household wealth and consumption.

Fed Impact on Corporate Investment Unclear

Capex (non-residential investment) tends to be driven more by the output gap than by interest rate (Chart 9). The output gap drives both the FFR and capex.

Similarly, corporate external fundraising, i.e., debt securities, loans and equity issuance tend to be positively correlated with the FFR because the Fed tends to tighten when the economy is strong, which is also when corporates need funding (Chart 10).

The exception to this pattern is the pandemic, when corporates raised massive amounts thanks partly to Fed guarantees, but the Fed cut interest rates. Fed tightening since 2022 has come with a marked decline in external fund raising. However, capex has remained resilient, possibly due an increase in profits that remain near historical highs and could have lessened corporate reliance on external funding (Chart 11).

This sanguine view on corporate funding needs to be qualified for smaller businesses, which report tighter access to credit.

Ahead, with GDP growth at 3% above its long-term trend of about 2%, the output gap is set to increase further and lift capex. The Fed’s planned easing could facilitate this process by boosting debt and equity markets, lowering issuance costs and improving SMEs access to credit.

A Recession Would Require Lower Equity and Home Prices

Consumption drives the US economy. It represents about 70% of GDP and its contribution to growth dwarfs that of investment (Chart 12). Therefore, slowing growth below trend would require slowing consumption. The above analysis suggests this could not be accomplished without causing a major decline in equities and home prices. Fine-tuning such a decline could be challenging.

My view aligns with a seminal paper published by Bernanke and Gertler 30 years ago. They argued the transmission of monetary policy tightening took place much more through its impact on asset prices, balance sheet strength, and access to credit than through an increase in the cost of capital.

Since publication, their view has not been tested because, until the pandemic, the US had not experienced high inflation. In addition, since the pandemic, the US economy has benefitted from positive supply shocks that have allowed disinflation to occur while growth remained above potential. The Fed SEP assumes disinflation will continue with above-trend growth.

Should inflation prove stickier than the Fed expects, I do not see the Fed trying to return it to target by engineering below-trend growth. The economic, financial, and political costs would be daunting.

Market Consequences

I still expect the Fed to cut twice in 2024 in line with market pricing 1.9 cuts, down from 2.7 cuts before the NFP.

Longer term, the Fed may have to revise its easing plans, though this revision would be unlikely before the 5 November elections.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)