The Federal Reserve’s recent downshift to 50-basis-point rate increases may just be an economic speed trap, says Goldman Sachs. Of course, that’s assuming people need to lose their jobs for the Fed to succeed.
There’s a chance the central bank will pick up the pace again next year after the initial shock of this year’s policy tightening wears off, according to a recent note from economist Joseph Briggs (who before this spent a few years working for the Fed Board of Governors).
To make this case, Briggs looks at exactly how interest rates affect the economy.
Instead of working with “long and variable lags”, as Milton Friedman famously said, GS’s economists argue that higher rates have the largest effect on growth merely 6 months after the Fed raises rates.
They also argue that they aren’t actually contradicting Friedman, and cite comments that say he preferred to measure the level of gross domestic product, not its growth. (We should mention that once the level of gross domestic product stops falling and starts rising, by definition, the economy is starting to grow again. ¯\_(ツ)_/¯)
Anyway, we will leave it to our readers to debate whether the bank’s economists are true Friedmanites or are debasing the monetarist’s legacy.
What’s most important, in their view, is how tighter Fed policy affects financial conditions measured Treasury yields, equity valuations, currency strength, corporate borrowing costs, etc.
And while the Fed raised interest rates again in December, financial conditions have already started to loosen from their tightest levels last month.
That’s mainly because investors think the Fed will continue to slow its rate hikes. The fed funds rate is around 4.3 per cent today, and most estimates call for rates to peak around 5 to 5.25 per cent. Stocks have rebounded a bit from their October lows, and Treasury yields/borrowing costs have retreated from early-November highs.
But Briggs writes that there’s a risk that the Fed will need to ratchet up the pressure again in 2023, because the real “lags” in the effects of Fed policy are felt in labour markets.
We should unpack the focus on job markets a bit, because that’s where this note gets its bite. The Fed is raising rates to control inflation, not to kick people out of work.
Check out the PCE entry in the chart above. That presumably references personal consumption expenditures, or BEA data that tracks changes in consumption. The prices for those goods and services are measured by PCE price index, which is the Fed’s preferred measure of inflation. The chart shows that PCE usually responds most to rate increases within three to six months.
Instead of including PCE price inflation in the chart above (assuming we didn’t misunderstand the labelling), Briggs addresses it with the chart below.
Here’s his explanation of the chart from the note, with our emphasis:
Although 50% of the cumulative effect of a US FCI shock on the level of GDP is realised within 2 quarters, the impact on other indicators generally takes longer. Specifically, we estimate that it takes 2-3 quarters for half of the impact on the jobs-workers gap to be realised, 3-4 quarters for wage growth, and a significant additional lag for wage-driven moves in inflation.
So he’s comparing the timing of a cumulative change in GDP to . . . changes in year-over-year rates of change (inflation and wage growth)? This Alphaville correspondent doesn’t have an economics PhD and doesn’t particularly want a headache, so we will rely on our readers to tell us if that’s reasonable.
Broadly, Briggs’ argument fits with a growing consensus: over the past two decades, the Fed has fought inflation primarily by raising rates until people lose their jobs. That almost always comes with a recession, but the bank’s house view is that there is only a 35-per-cent chance of recession in 2023.
If causing a recession is the only way to fight inflation, the central bank may in fact need to keep raising rates next year.
But this inflation has occurred in the wake of a pandemic and war, which both created massive supply shocks in important sectors like food and energy. Economists are arguing those sectors have systemic and outsized effects on inflation, as Robin wrote recently.
So barring any other supply shocks — and really, who knows? — 2023 should be a good opportunity to test their theory and see if inflation slows. Otherwise, the Fed might be taking a sledgehammer to the economy in an attempt to fix it.
