The considerations of the governors of the Federal Reserve this week on the question of how much more to raise the interest rate will depend on the extent of the slowdown they expect for the economy this year. One of the decisive factors in their two-day meeting will be the assessment of how much the previous interest rate increases have cooled growth and inflation over time, or what Nobel laureate Milton Friedman called the “long and variable” lags or delays of the impact of monetary policy.
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“There’s going to be a lot of thinking about the question, ‘Are the impacts we’re getting roughly on the path we expected? Are they coming sooner, or are they bigger?'” said William English, a former senior economist at the Fed and now a lecturer at Yale University’s School of Management.
Fed governors raise interest rates to lower inflation by curbing growth. On Wednesday, they are expected to raise the benchmark interest rate – the federal funds rate – by a quarter of a percent, to a range between 4.5% and 4.75%, thus continuing the fastest regulation of interest rates since the early 1980s.
If the lags in policy effects are long, then last year’s increases are just beginning to make their way through the economy, and will cool economic activity to a large extent this year. What this means is that the Fed does not need to raise interest rates much longer, or keep them high for a long period of time.
But if the delays are short, then the previous interest rate increases have already mostly had an effect, and the central bank may decide to raise the interest rate further, or leave it high for a longer time to achieve the desired effect.
Slowing the pace of rate hikes will give the Fed more time to examine the effects of its measures. A quarter percent hike this week could slow those effects for a second consecutive policy meeting, after last month they raised interest rates by half a percent – after four consecutive three-quarter percent hikes.
The interest rates set in the markets have stopped rising
Many investors think the lag in policy effects is long: They expect the Federal Reserve to cut interest rates later this year and into 2024, because they believe the central bank has already raised interest rates to a level that would likely trigger a recession. As a result, medium- and long-term interest rates set by the markets, including on most US mortgages, have stopped rising, or even started to fall, even though the Fed continues to raise short-term interest rates.
Economists at Goldman Sachs think the delays are shorter. They say that the pessimism of the markets is exaggerated, and they are among those who think that the economy will prove to be more resilient than expected, which could result in a longer period of high interest rates.
“While the consensus fears that the delayed effect of interest rate hikes will cause a recession this year, our model says the opposite – the delay in GDP growth resulting from monetary policy tightening will be significantly reduced in 2023,” said David Mericle, chief US economist at Goldman Sachs.
Several Fed governors said interest rate changes are affecting the economy more quickly because governors are expressing their policy intentions more clearly than in the past. 30 years ago, for example, the Fed did not inform the public if it made interest rate changes at policy meetings.
“The market should have realized on its own that the Fed did something there. In this world, policy takes time to affect the economy,” Fed senior official Christopher Waller said earlier this month. In contrast, today’s Fed provides guidance on its expected actions, thus shortening delays. “I think we’re seeing a lot more of the impact of monetary policy pass through to the market in the last quarter,” Waller said.
Others say such an approach ignores important changes that have lengthened the delays. Even as Fed governors shortened the time between changing the benchmark interest rate and affecting financial conditions, they did not shorten the time it takes for financial markets to affect economic activity. Those secondary effects may be taking longer than before, in part because of distortions created during the pandemic, said Anita Markowska, chief economist at Geoffrey’s.
In 2020-2021, the government’s response to the pandemic – targeting cash to households through aid spending and reducing borrowing costs for individuals and businesses – prevented the usual crisis pattern of rising unemployment, which increases declines in income and spending, and causes a recession. This left the private sector balance sheet in a historically strong position.
“We’re in a different world compared to some previous business cycles,” said Donald Cohen, a former vice president at the Federal Reserve. “In recent cycles there were no plagues and wars on the European continent.”
Interest rate hikes can slow the economy more immediately when economic growth is driven by credit growth, as opposed to income growth and government aid, which were the big engines of the pre-pandemic recovery. The flip side of that is that this time it could take longer for the Fed’s actions to be felt in the economy, Markowska said.
“Obviously everything is starting to move more slowly”
Consumer spending and income growth slowed at the end of last year, alongside the slowdown in inflation. The Ministry of Commerce reported last week that one of the indicators of demand, final sales to household buyers, which does not include inventory and wholesale trade, rose by only 0.8% per year in the fourth quarter, in a seasonally adjusted calculation.
“If you look under the hood of the economy, it’s clear that things are slowing down. Everything is starting to move more slowly,” said Ray Ferris, chief economist at Credit Suisse.
The Fed’s change in interest rates did not slow the economy last year as much as might have been expected because the economy was still awash in fiscal and monetary aid that supported activity, Fed Vice Chair Lal Brainard said earlier this month. “It’s reasonable to think that the full impact on demand, on Employment and inflation from the cumulative tightening that is in the pipeline is still ahead of us,” she said.
Big companies have been immune to the Fed’s interest rate hikes for now because, before it started, they were able to secure low-cost borrowing for several years ahead by issuing corporate bonds.
Small businesses, on the other hand, may feel more pressure this year from high interest rates, because they rely on loans from banks or on shorter-term loans, the costs of which will soon become more expensive.
Consumer spending will be one of the keys to how much the economy slows down this year. Meanwhile, households have not pulled back much in response to higher inflation, partly because many accumulated large savings early in the pandemic.
Markowska says low-income consumers likely have exhausted those protections because the amount of credit card debt is rising. She assumes that many households will use up their savings by November, and cut back on spending.
Mericle of Goldman Sachs sees less reason for consumers to start saving again, because inflation-adjusted incomes are expected to rise if inflation in general continues to slow. With price increases less damaging to household wages, “it’s just not realistic to pull in excess savings in 2023 as much as we did in 2022,” he said.