In the iconic 1936 film, Silver Blaze, Sherlock Holmes noted that the absence of evidence can be as significant as what is seen or heard. ‘The dog that did not bark’ offered critical information that an insider stole the racehorse, allowing Mr. Holmes to solve the crime.
Economists could learn a thing or two from the famous sleuth. Obsessed with data, economists look for answers where numbers reside. But answers may not always be found there. To our detriment, data-driven investigations can skew our focus away from what is genuinely significant.
That’s true today for monetary policy. Two years ago, the world’s most important central banks began to hike interest rates. Global monetary policy tightening was concerted and aggressive, coinciding in all major economies apart from China.
Predictably, economists began to forecast recession. They drew support from the most widely followed leading indicator of the business cycle, an inverted yield curve, which hitherto had flawlessly predicted recessions.
And yet the recession dog has so-far refused to bark.
Ok, Europe has skirted recession in recent quarters and technically Japan dipped into recession last year with consecutive quarters of falling real GDP.
But the focal point was the US economy, which has barely slowed, never mind shrunk. Rather, since 2022 the US economy has produced the longest consecutive quarterly streak of sub-4.0% unemployment in five decades, while simultaneously delivering falling inflation which is now nearing the Federal Reserve’s 2.0% target.
Last year, the US recession ‘hound’ was silent. It neither growled nor whimpered.
So, equipped with little more than our deerstalker caps, pipes, and magnifying glasses, we’re setting out to explore why the US recession dog snoozed. And our interest isn’t merely forensic. The more we dig around, the better equipped we may be to understand the workings of the US economy and financial markets, unearthing relationships that may help us better understand future business cycles and market risks.
What Others Say
We begin by looking at what other economists have been saying about the linkages between central bank actions and economic activity.
One paper published last year by economists at the Federal Reserve Bank of Kansas City argued that the growing share of US employment in services (as opposed to manufacturing) has made the labor market—and by extension household income and spending—less sensitive to changes in interest rates. As a result, the authors wrote, the lags between monetary policy tightening and economy-wide spending have lengthened. One key reason, the Fed researchers suggest, is that service sectors tend to be less capital intensive, and accordingly have lower levels of debt.
A survey of the literature conducted by the Federal Reserve Bank of St. Louis points to another factor behind the delayed response of the economy to rate hikes, namely the presence of long-term contracts that offer businesses greater assurances about future demand, thereby diminishing the need for short-term adjustments in employment, investment, and other spending that might otherwise respond to changes in borrowing costs. Long-term fixed contracts enable the economy to be shielded—at least for a while—from Fed rate hikes that would otherwise weaken capital expenditures or increase layoffs.
But not everyone agrees that lags between monetary policy decisions and economic outcomes have lengthened. In a paper written last year, Federal Reserve Governor Waller argued that lags have, in fact, shortened between changes in Fed policy and economic outcomes. Waller argues that smooth transitions over the business cycle, as derived from statistical models, often ignore factors that could have more immediate and larger impacts.
Among them, Waller notes, is the potential for changes in monetary policy to rapidly shift asset prices, including long-term interest rates, via the credibility effects embedded in ‘forward guidance’. Accordingly, changes in both monetary policy and its communication can more quickly ripple across the economy. Mortgage borrowing costs, for example, may rapidly adjust to reflect expected policy rate hikes, leading to a faster slowdown in residential investment. In short, Waller suggests that the transmission of monetary policy has recently sped up relative to history.
At this point, readers can be forgiven for a asking whether economists have a clue about how quickly monetary policy impacts the economy. After all, if the best and brightest working at the Fed can’t agree, then perhaps no one knows the answer.
What We Think
But, as it turns out, the evidence from this cycle is becoming clear. Fed rate hikes are not slowing growth much, if at all. The Fed started hiking rates aggressively in early 2022 and two years later US real GDP growth keeps chugging along, blissfully keeping the unemployment rate under 4.0% and near 50-year lows. If anything, Friday’s employment report points to an economy re-gaining momentum.
So, either the lags between rate hikes and economic weakness have lengthened (contrary to Waller’s thesis) or, perhaps, the economy is not as sensitive to changes in interest rates as it once was. A third option is also possible, namely that other forces are offsetting Fed restraint, keeping the economy ticking over.
In our view, all three factors—longer lags, less interest rate sensitivity, and other expansionary forces—have thwarted the forecasts of most economists who had thought that by now the US economy would be buckling under the pressure of the most aggressive series of US rate hikes in over three decades.
Longer lags are likely and due to factors previously cited, including over 80% of total employment in services, which are typically less cyclical. The capital stock of a knowledge-based economy is embedded to a greater extent in human capital (education, skills), in intangibles (patents, innovations, brands, marketing) and less physical capital-intensive investments (software). As a result, rising borrowing costs impact fewer firms and a smaller proportion of employed Americans than in past cycles.
Indeed, one of the more remarkable observations in this cycle has been the improvement in net interest income of the non-financial corporate sector since 2022. Among publicly traded companies (e.g., the S&P500), firms flush with cash have seen their earnings on short-term deposits rise faster than their cost of borrowing. Rising net interest income when the Fed hikes rates is a stunning outcome, and it has blunted an historically important transmission channel of tighter monetary policy to the economy.
Anomalies are present in other parts of the economy as well. As a by-product of the changed regulatory and lending environment following the global financial crisis of 2008, US household mortgage borrowing shifted sharply after 2010 toward conventional fixed-rate thirty-year mortgages. Accordingly, Americans who locked in low mortgage borrowing rates prior to 2022 have been largely insulated from rising interest rates in recent years.
Long-term mortgage finance has contributed to another oddity of this cycle, namely still-strong demand for new home construction. The reason is that existing homeowners, who benefit from low mortgage rates, are less willing to sell their homes. Meanwhile, strong employment growth undergirds demand for housing. As a result, homebuilding and home prices have not buckled in this episode of Fed tightening as they did in the past. Indeed, the Case Shiller home price index is up more than 6% over the last year and has risen by 12% since the end of 2021.
A further factor which has insulated the US economy from the full effect of high interest rates has been the falling ratio of household debt to disposable income, which has dropped by a third since the global financial crisis. Relative to their after-tax income, Americans are less leveraged today than at any time in a generation, meaning that higher interest rates are more easily absorbed in household cash flow.
Finally, it is worth noting that Fed tightening has been partly blunted by other sources of demand. Unlike in the 1990s or following the global financial crisis, US fiscal policy today is not contractionary. Budget deficits, as a percentage of GDP, are not declining rapidly. The Fed may be applying brakes to the economy, but Congress is not.
Conclusions
Economists armed with models calibrated on historical data typically produce insights that help us better understand the business cycle. But sometimes it pays to go beyond traditional models. It’s worth asking if we are missing something—a dog that proverbially refuses to bark.
Noting that today’s economy has held up better to Fed tightening than many expected behooves us to consider whether structural changes to the real economy and to private sector finance may have lengthened the lags between Fed policy and economic outcomes, or even diminished the overall effectiveness of monetary policy.
In our view, the US economy has become less sensitive to changes in interest rates, meaning that lags between rate hikes and economic activity have also lengthened.
One might conclude that the Fed must therefore tighten more, or at least leave rates high for longer. But with US inflation now approaching the Fed’s target, the need to push the economy below trend growth is no longer as pressing. As a result, a more resilient US economy may not require as much pain to restore the Fed’s dual mandate of price stability and maximum employment.
