Monetary Policy Lags: How Long & How Variable? 

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

A common refrain over the past year or so has been the market’s overexuberance about the prospects for Fed rate cuts. In fact, fed funds futures projections have been consistently optimistic on this front, calling for more rate cuts than the Fed is explicitly telegraphing may be in the cards for 2024. Back in December, the median respondent in the Fed’s dot plot survey called for 3 rate cuts this year, which the market took as an opportunity to price in 6 – 7 cuts. Ever since then, the market has backed off on those expectations and drifted closer to the Fed’s estimate, especially as Chair Powell recently threw cold water on the likelihood of cuts in March.

Assuming the Fed’s estimate is the more credible base case, fed funds is on path to remain in restrictive territory through at least year-end. In fact, rates have been above neutral (that is, the level of fed funds that is neither economically restrictive nor stimulative) since the fall of 2022. Historically, when monetary policy has been this tight for this long, it usually results in recession. The caveat is that monetary policy famously impacts the economy and growth with long and variable lags. How long and variable? The experience over the last three economic cycles (excluding the COVID recession which was a bit more event driven) has been lags of roughly one to two years. That sort of timeline suggests that the peak impact of tight policy should be occurring about now.

When thinking through the impacts that rates have on the economy, it may be helpful to reason through both its direct and indirect impacts. Let’s take the consumer for example. One of the direct impacts of higher rates is on those that borrow at non-fixed, variable rates. As rates go higher, their debt service costs increase, all else equal. Mortgages are by far the largest category of consumer borrowing in the U.S. The share of applications for mortgages that carry adjustable rates has declined considerably over time, especially in the wake of the Great Financial Crisis. Therefore, it’s not entirely crazy to argue that the consumer may be less rate sensitive now than it has been in the past. Even those that have taken out adjustable-rate mortgages have not seemed to face material stress yet, as the share of those with payments past due remains near multi-decade lows.

However, that’s not to say that households are not rate sensitive at all. Indirect transmission mechanisms of monetary policy are the other side of this coin. These impacts are indirect in the sense that they affect the decision-making process for consumers looking at new borrowing. Consumers may be less likely to take on new debt obligations with rates so high and bank lending standards so tight. The growth in consumer credit tends to follow trends in the willingness of U.S. banks to extend new loans, suggesting that new endeavors that tend to be the driving force behind economic growth may be disincentivized. This should be a headwind for economic growth as long as rates remain as high as they are.

So to summarize, the market has recently been adjusting its expectations regarding rate cuts, though it still anticipates a more aggressive easing trajectory compared to Fed projections. Monetary policy is notorious for its delayed effects on the economy, but historical patterns suggest that the peak impact should be happening around now through the back half of the year. This time around, consumers might not be as directly affected by changes in rates, especially considering the trend away from adjustable-rate mortgages. However, given these high rates and strict bank lending standards, consumers may be less inclined to take on additional debt that could fuel further economic growth. Even though the U.S. economy may be less sensitive to rates than in the past, that doesn’t mean it’s lost all sensitivity. As a result, monetary policy headwinds are likely to peak around now through the back half of the year.

Thanks for listening! And please don’t hesitate to reach out with any questions.