When confused, re-evaluate your model
In recent months, we’ve seen an almost endless series of opinion pieces discussing the supposed “mystery” of why tight money has failed to slow the economy. Yet almost no one seems to question the assumption that a tight money has been adopted in the US and elsewhere. In this post, I’ll show that there is no mystery to be explained; the economy is reacting today as it has always reacted.
Today’s Financial Times provides a good example of the media’s confusion:
Monetary policy always comes with a lag, taking about 18 months for the impact of a single rate increase to fully seep through into spending patterns and prices.
Monetary policymakers began raising rates less than a year and a half ago in the US and UK, and less than a year ago in the eurozone. They went higher than the neutral rate — where they are actively restricting the economy — only a few months ago.
But some central bankers and economists believe lags may be even longer — and the effect of the tightening less potent — this time around.
“Maybe monetary policy is not as powerful as it was several decades ago,” said Nathan Sheets, chief economist at US bank Citi.
There is a much simpler explanation. Interest rates do not show the stance of monetary policy. Policy was not tightened in 2022; indeed it remained quite loose. When policy does get tight, the effects will be almost immediate. Here’s a point I cannot emphasize enough:
Interest rates are a procyclical variable.
A long-term shift away from manufacturing towards services, which require less capital, could also mean slower transmission of a tighter monetary policy.
Just the opposite is true. In an economy that requires less capital, the neutral interest rate is lower. Any given policy rate then implies tighter money. Indeed this may help explain why the neutral rate fell to such low levels in the 2010s.
Structural changes in important parts of the economy — including housing and labour markets — between now and the 1990s may explain why rate rises had a much snappier and sharper impact then.
I’m afraid the FT has misremembered the 1990s. Interest rate increases did not have a “snappier and sharper impact” back then:
Notice that there were two periods of rising rates during the 1990s. The sharpest occurred in 1994, and not only was its impact not “snappier and sharper”, it had almost no impact on the long 1990s economic boom. Inflation was 2.6% in 1994, 2.8% in 1995, and 2.9% in 1996. (It slowed in 1997 due to the East Asia crisis, not anything the Fed did.)
The second period of rising rates began in January 1999. A full two years later the economy was still not in recession. In contrast, we are less than 18 months into this tightening cycle.
No, there was no Golden Age when rate adjustments explained macroeconomic trends. The Fed enacted many rate increases between 1965 and 1981, and yet inflation rose higher and higher. Sharp rate cuts in 1929-30 failed to arrest the severe deflation of 1929-33.
How can we learn from history if we don’t even know the facts? There’s never been a close correlation between interest rates and the macroeconomy. Interest rates are not monetary policy.
PS. I wrote a whole book on the subject. It’s free.