What Has Policy Tightening Accomplished So Far?
Interest rates have jumped, which has coincided with a drop in bank lending, M&A, and consumer borrowing, while government spending is down. But the economy as a whole seems blissfully unaffected.
It is has been more than 18 months since the Federal Reserve pivoted from boosting the economy to fighting inflation, and it has been roughly that long since the government ended its pandemic-related emergency spending. The timing lines up nicely with the turnarounds in measures ranging from the share of workers quitting their job for better opportunities elsewhere to the Federal Reserve Bank of New York’s index of “global supply chain pressure”.
Does this mean that higher interest rates and tighter budgets somehow caused inflation to decelerate as much as it has?
While I think that the changes in policy were broadly appropriate, I am not convinced that they explain much of what we have observed so far. As I put it in a footnote in my previous note, “I do not see why the withdrawal of temporary measures imposed during an emergency should be considered economically significant compared to the end of the emergency itself.” The changes in monetary and fiscal policy so far have not been consistent with what would be required to force inflation out of the economy by squeezing incomes and spending. There has not been tightening so much as normalization.
Fiscal Tightening Normalization
Government spending has (rightly) plunged compared to 2020-2021. Both outlays and receipts are more or less back on trend, although rising interest expense and diminished capital gains tax receipts are pushing both in the “wrong” direction.
No one seriously suggested that levels of spending that were appropriate during the pandemic should have persisted after the end of the emergency. If that had happened, it almost surely would have been inflationary. But spending returned to the pre-pandemic trend before inflation began to decelerate, while the budget deficit has been widening even as inflation has finally been slowing down. Fiscal policy was helpful insofar as it was not actively counterproductive, but it does not seem right to give the budget much of a role in the inflation slowdown.
Monetary Tightening Normalization
Fed officials began changing their tone on inflation risks and the need for action around November 2021. From then through October 2022, shorter-term real interest rates jumped by roughly 4 percentage points. That was a dramatic move, and it was painful for the owners of the junkiest risk assets.
But while the speed of the change in interest rates was abrupt, the move looks much more benign when viewed in context. The current level of real rates is no different from what was considered “normal” as recently as 2014—and the economy is much stronger now than it was in 2014.
Moreover, it is at least plausible that an investment boom powered by the combination of green subsidies, reshoring, and rearmament will boost the longer-term growth trend and require persistently higher interest rates than were appropriate in the lost decades of the 2000s. From that perspective, prospective real interest rates do not seem high at all.
This, along with other important factors, may explain why the jump in rates seems to have had so little impact on real economic activity.