Friday, October 14, 2022

Rate Hikes Are Loose, Not Tight, Monetary Policy

Public (and private) discourse about inflation and rates is truly bizarre. Consider the following scenarios:

Scenario A:

Savings account beginning balance = $10,000

Savings account ending balance = $10,000

No contributions or withdrawals over the period

Time lapse = 1 year

Scenario B:

Savings account beginning balance = $10,000

Savings account ending balance = $10,300

No contributions or withdrawals over the period

Time lapse = 1 year

The only difference between Scenarios A and B is the ending balance, for which B is $300 more than A. It is self evident that Scenario B is more expansionary than scenario A - there are literally more dollars at the end of a year in Scenario B, whereas Scenario A's balance is flat. And yet, according to the economists at the Fed, the media, Wall Street, elected officials, most of academia, and basically everyone with an "informed" opinion on the subject, Scenario B is considered a form of monetary tightening. The finance and economics professions are some of the highest paid industries in the country, and generally employ our nation's "best and brightest" or "Masters of the Universe." And yet despite this incredible brain trust, people continue to accept the axiom that rate hikes = monetary tightening, generally without thinking twice about it. The Fed has never released any research supporting the assertion that rate hikes "tighten" credit, limiting the availability of credit and subsequently tightening the money supply. Over the past year, the Federal Funds Rate (i.e. the rate that banks lend reserves to each other overnight) has gone from nearly 0% to around 2.5%:

This has resulted in the 10-year US Treasury, the risk-free rate for which all securities are priced off of, to rise from around 1.5% a year ago to nearly 4% today:

And yet, despite this "tightening," credit growth has remained strong:

And the employment to population ratio has ticked higher:

With US debt to GDP at around 120%, the impact of rate hikes on US federal spending is amplified. Total interest paid on Treasury debt is up nearly 30% year-on-year:

This increase in federal spending is a form of fiscal stimulus for people with savings. Similar to the checks sent out to Americans in 2020 and 2021, this increase in government spending stimulates aggregate demand (albeit to a wealthier cohort than the COVID stimulus programs).

And yet, the vast majority of the population calls this "tightening."

While we have been fairly negative in our outlook for the economy, it appears these rate hikes are having the unintended effect of stimulating aggregate demand, keeping us out of recession. In addition, federal programs such as the CHIPS Act, the Inflation Reduction Act, and President Biden's executive order to cancel a portion of student loans are further sources of stimulus that are coming down the pike. The student loan cancellation is especially important: Penn Wharton has modeled the program will "cost" over $500 billion in 2022 (in reality, it's not a cost but rather savings for households who qualify). Functionally, this is a tax cut: it reduces households' payment obligations to the federal government. And it is progressive, as it targets lower-income households. This is a very positive development for the US economy, as it creates capacity for these households to borrow and spend money on things like a house, a car, or other productive goods.

I'm not ready to go all-in on US avoiding a recession, but these developments are noteworthy and the Atlanta Fed GDPNow predictor indicates 2.9% growth for the third quarter:

Remember: savings don't drive investment, it's the other way around - investment creates savings. When consumers and businesses borrow and spend, that spending creates income. Rate hikes ostensibly are a form of increased government spending, which increases income for those with savings. Recall the scenario comparison above: in Scenario A, rates were at 0% and there was no change in the savings balance over the course of a year. In Scenario B, the interest rate was 3% which resulted in a higher savings balance at the end of the year. People make economic decisions based on real supply/demand factors. If a family decides it needs to buy a house to accommodate the birth of a child, they will pay the rate that's offered - assuming they can afford it. Whether they can or can't is a matter of a host of other economic factors. Rate hikes impact the distribution of income - people with savings get paid more at the expense of people who are net borrowers. That can have very negative economic effects. But to call that "tightening" is a stretch.

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