Today’s Points |
- Tighter money still isn’t slowing the US economy because:
- Money supply is growing
- Companies are paying less in interest thanks to cheap fixed rates
- Disinflation is stimulating the economy.
- US house prices survived 8% mortgage rates, so less pressure for lower fed funds rates
- TIP: Watch John Stewart
Why the Lag? |
Milton Friedman, the godfather of monetarism, famously declared that monetary policy worked with a lag. Change the supply of money, or change the rate of interest, and its effect would only show up in the big economic aggregates more than a year later. But since the unprecedented shock of the pandemic, it’s experiencing the longest lag in history. Secretariat-like, the economy continues to gallop far ahead of the Fed. The dramatic rise in interest rates engineered by the Federal Reserve has, to date, had little discernible impact on economic growth or employment. Working out just why this has happened now becomes critical both for the Fed and investors as they try to navigate a course through the post-Covid world.
One explanation, from keepers of the flame of monetarism, is that the supply of money remains far ahead of its long-standing trend. If we look at month-on-month changes in M2, a broad measure of money supply, what happened in the early months of 2020 stands out as an unequaled dose of adrenalin. It’s true that M2 has declined much of the time since the Fed started hiking rates in 2022, and that it’s the change at the margin that normally matters — but this was quite a shock:
Tim Congdon, a former adviser to Margaret Thatcher and now head of the Institute of International Monetary Research, points out that by an even broader measure called M3, December saw an increase of almost 0.6% (an annualized rate of 7.2%). In the six and three months to December, he says, the annualized rates of increase in M3 were 3.1% and 4.6% respectively — consistent with steady economic growth, and also very surprising in the context of rising interest rates. His suggestion is that the federal government is funding its deficit by borrowing from banks, which has the effect of increasing money in circulation.
Whatever the reason, the effect is that M2 remains ahead of its steady trend of growth which had persisted for three decades leading into the pandemic, with the Global Financial Crisis of 2008 barely even causing a blip:
That’s one way monetary policy is out of kilter with previous episodes. A second is suggested by old friend Jim Paulsen, a long-term economist and investment strategist who’s now publishing a Substack newsletter in retirement. He argues that this tightening cycle is unlike any before it because the hiking didn’t start until inflation was virtually at its peak. The long gap while rates stayed effectively at zero and inflation surged toward 9% is marked on the chart:
That goes a long way toward explaining why the lag is operating differently this time. Rates have risen (a depressing effect on the economy) at the same time as inflation has come down (which should stimulate the economy) and have canceled each other out, just the way as the effect of the preceding inflation that was cushioned by zero interest rates.
Another issue is that the Fed’s long wait created far too generous a window of opportunity for companies to lock in low rates. That insulated them from the tightening that followed. The following chart, from the St. Louis Fed’s economic data, or FRED, service, shows that the interest expense that non-financial companies pay now is no higher than it was two decades ago:
It’s certainly possible to argue that this number remains dangerously high in absolute terms — but in terms of its effects on company behavior, tighter monetary policy has thus far produced little inducement for firms to pull in their horns. Companies have also been helped by lower corporate taxes, and by the interest that they earn, which has had the effect of reducing net interest bills to very manageable levels. In the following chart, from Societe Generale’s chief quantitative strategist Andrew Lapthorne and drawn on the latest results published by companies in the broad S&P 1500 index, we see that companies’ net interest costs after tax are actually down. No wonder it’s taking time for monetary tightening to have an effect:
A further point that Paulsen makes is that historically, disinflation tends to administer a stimulus to the economy over the following 12 months, even though it often results from an economic slowing down. These charts show subsequent growth in the year after months when inflation was down on a year earlier, compared to performance after months when inflation was rising. Growth averages 3.8% after disinflation, and 2.6% after inflation. Productivity growth is 2.4% following disinflation and 1.8% following inflation.
Using the same simple system, Paulsen also found that employment growth was 2% after disinflation (compared to 0.3%) while consumer confidence rose by 8% over the following year, compared to a 17% fall after inflation. Earnings per share for the S&P 500 grew at a 23.8% clip, compared to only 4% in times of inflation. The intuition is clear enough; people like falling inflation. It affects them much like a tax cut, and tends to make them behave in ways conducive to growth. To the extent that much of the recent inflation spike and its subsequent decline were driven by factors beyond the Fed’s control, such as clogged supply chains, then the attempt to throw sand in the economy’s wheels with higher rates has been counteracted by the boon of disinflation pouring in.
Looking at productivity growth, Paulsen found a negative correlation with inflation — when prices are rising faster, it’s harder to improve productivity. Generally, the relationship is clearer during recessions than expansions, but the current expansion is a big exception:
It’s at least possible that inflation is stoking productivity. The scale of the monetary expansion during the pandemic, and then the weird sequencing since, has made this a tightening like no other, and has produced a lag longer than any other.
This suggests that there need be little urgency for the Fed to start cutting. Meanwhile, the booming stock market raises the risk of overheating and makes cutting harder. And then there’s the housing market. Sharply rising mortgage rates put pressure on the central bank to alleviate the situation and prevent a housing bust. After the latest numbers, it’s not clear that’s necessary...
No comments:
Post a Comment