Fed's Rate Hikes Clash With Economic Resilience, Growth Persists

Key Takeaway

• Despite Fed rate hikes, the US economy remains robust due to growing money supply, low corporate interest expenses, and disinflation stimulating growth.
• Housing market resilience and modest home price increases suggest less immediate need for Fed rate cuts.
• The unique post-pandemic economic conditions have created an unprecedented lag in monetary policy's impact on the economy.

The Lagging Impact of Tighter Monetary Policy

The Federal Reserve's efforts to tighten monetary policy have not had the expected impact on the US economy, with a significant lag in the transmission of policy changes. Despite the Fed's dramatic rise in interest rates, economic growth and employment have not shown a substantial response. This delay in the effectiveness of monetary policy poses a challenge for both the Fed and investors navigating the post-Covid economic landscape.

Monetary Policy and Money Supply Dynamics

The current tightening cycle is unique in several aspects, notably the unprecedented growth in the money supply following the pandemic shock. Measures like M2 and M3 show significant increases, suggesting that the federal government's deficit funding through borrowing from banks has boosted money circulation. This divergence from historical trends in money supply growth complicates the Fed's efforts to influence economic conditions through interest rate adjustments.

The Impact of Inflation and Corporate Behavior

The timing of the Fed's interest rate hikes coinciding with peak inflation levels has created a scenario where rising rates and falling inflation counteract each other's effects on the economy. Companies have capitalized on the prolonged period of low rates to lock in favorable borrowing terms, shielding them from the tightening monetary policy. Lower corporate taxes and interest earnings have further mitigated the impact of monetary tightening on firms, delaying the expected response to policy changes.

Disinflation as a Stimulus and Productivity Driver

Historically, disinflation has stimulated economic growth by boosting consumer confidence, employment, and earnings per share. The recent decline in inflation, driven by factors like supply chain disruptions, has acted as a stimulus for the economy, offsetting the restrictive effects of monetary tightening. The relationship between inflation, productivity growth, and economic expansion is complex, with disinflation potentially enhancing productivity in the current economic environment.

Housing Market Dynamics and Fed Policy

The housing market, a key indicator of economic health, has shown resilience despite rising mortgage rates. The Fed's pivot towards lower rates in response to housing market pressures has contributed to a decline in mortgage costs, supporting housing price stability. As house prices recover and affordability remains a concern, the Fed's cautious approach to rate cuts reflects a desire to avoid past mistakes and maintain economic stability.

Street Views

• Tim Congdon, Institute of International Monetary Research (Neutral on the US economy):

  "The federal government is funding its deficit by borrowing from banks, which has the effect of increasing money in circulation."

• Jim Paulsen, Economist and Investment Strategist (Neutral on Federal Reserve's tightening cycle):

  "This tightening cycle is unlike any before it because the hiking didn’t start until inflation was virtually at its peak... Rates have risen at the same time as inflation has come down and have canceled each other out."