How monetary policy works

With the yield curve rapidly flattening, a lot of chatter in the investment world has turned toward the question of when the yield curve will invert.  This is especially pertinent since the last nine recessions (and associated bear markets in equities) have all been foreshadowed by yield curve inversions, despite the unique historical circumstances that preceded each of the recessions.  There was only one false positive, in the mid-1960s, which was followed by an economic slowdown.  Note that flattening typically does not portend a recession – only inversion does.  Also, the lead time between inversion and recessions has ranged between 6 and 24 months over the past 60 years.

Typically, a flattening yield curve, and eventually an inverted one, has been driven by rapidly rising short-term interest rates, while long-term interest rates rose at a much slower pace, if at all.  Yet, the mechanism that links yield curve inversions to recessions is not clear and so there is always a question of whether “this time is different” – including by Fed Chair Ben Bernanke after the yield curve inverted in 2006.

In this cycle, a lot of focus has fallen on the fact that global bond markets have been warped by unconventional monetary policy over the past several years.  Bernanke, once again, suggests that the yield curve’s power to signal a recession may have diminished because normal market signals have been distorted by regulatory changes and quantitative easing in other jurisdictions.

On the other hand, as Minneapolis Fed President Neel Kashkari points out, “this time is different” may be the four most dangerous words in economics.  He says that if the Fed continues to raise rates, not only are they risking yield curve inversion, but also contractionary monetary policy that will put the brakes on the economic recovery.  Though the question remains as to how this may happen.

A Fed-induced recession?

As an economic expansion moves along, the Federal Reserve tightens monetary policy – raising short-term interest rates – at a faster pace to combat inflation and avoid over-heating of the economy.  The expectation is that long-term rates will also rise, since these should reflect expected future values of short-term rates (as well as a term premium).

As the Federal Reserve notes on their website:

Monetary policy influences inflation and the economy-wide demand for goods and services — and, therefore, the demand for the employees who produce those goods and services — primarily through its influence on the financial conditions facing households and firms. 

The story goes as follows: when short and long-term interest rates go up, it becomes more expensive to borrow.  So households start borrowing less, and spending less.  Businesses also pull back on plans to borrow money and make capital investments, leading to less workers getting hired and lower production.  The reverse occurs whenmonetary policy is loosened and interest rates fall – lowering the cost of capital.

Curiously, this linkage between tighter monetary policy and a slowdown in private credit growth is not readily apparent when we looked at the previous four economic expansions in the US: 1970s (Q2 1975 – Q4 1979), 1980s (Q1 1983 – Q2 1990), 1990s (Q2 1991 – Q1 2001) and 2000s (Q1 2002 – Q3 2007).

The following chart shows year-over-year growth in private credit to non-financial institutions across the four expansions – each panel starts from the last quarter of a recession through to the first quarter of the following recession (we combined the 1980 and 1981-1982 recessions).  The interim periods during which the Federal Reserve was raising interest rates (as defined by the effective federal funds rate) are highlighted in pink, and recessions are shaded gray.

Total credit to private non-financial sector for the US.  Year-over-year change as percent (quarterly data).  Source: FRED.

As the panels illustrate, private credit continued to grow even when monetary policy was tightening.  During the late 1970s tightening cycle credit expanded at a faster rate of almost 14 percent year-over-year.  In the late 1980s, the pace of credit growth slowed when the Fed was raising rates, but it still grew at an annual rate between 8 and 10 percent.  In contrast, the 1990s and 2000s tightening cycles actually coincided with a pickup in the pace of private credit growth.

In each case, the pace of credit growth fell significantly only after the economic expansion ended, and credit growth turned negative only during the most recent recession (2007 – 2009).

So something is clearly amiss with the usual story.  A piece by Srinivas Thiruvadanthai , an economist and Director of Research at the Jerome Levy Forecasting Center, directed us to several papers and a Federal Reserve survey suggesting that business capital spending plans are not sensitive to interest rates (also discussed on a recent Bloomberg Odd Lots podcast).

However, housing is another matter.

The monetary transmission mechanism 

Economists like Paul Krugman have pointed out in the past that the monetary transmission mechanism works largely through housing (and more recently, the exchange rate).  Investments that last a long time, like homes, are a lot more sensitive to interest rates than shorter term investments.  Most business investments are more short-lived (like computers) and so interest rates are not as significant a factor in those decisions.

The following exhibit shows housing starts across the previous four expansions.  Once again, each panel starts from the last quarter of a recession through to the first quarter of the following recession.  The interim periods during which the Federal Reserve was raising interest rates are highlighted in pink, and recessions are shaded gray.

Total housing starts (1000s of units).  Seasonally adjusted annual rate (quarterly data).  Source: FRED.

Housing declined sharply during tightening cycles in the late 1970s and 1980s, by -45% and -22%, respectively.  The tightening cycle in 1994-1995 saw a decline of -18%, though this period was not followed by a recession and housing starts picked up again over the next four years (as the Fed lowered rates and kept them them low).  The next two tightening cycles coincided with the housing bubble but even then housing starts declined, by -5% in the late 1990s and -10% in the mid-2000s.

We also looked at the various components of GDP – personal consumption expenditures, nonresidential investment and residential investment – over the past four expansions, and see the same story.  Tightening cycles have coincided with declining residential investment across each of the past four expansions.  This is in contrast to personal consumption and private nonresidential investment, which continued to grow even as the Fed was raising rates.

This can be seen in the next exhibit, which shows the growth of personal consumption expenditures, private nonresidential investment (structures, equipment, intellectual property products) and private residential investment across the four expansions.  In each expansion panel, these three components of  GDP are indexed to 100 in the final quarter of the prior recession – so what you see is the cumulative growth of each component during the expansion.

Growth of personal consumption expenditures, private nonresidential investment and private residential investment (indexed to 100 in the final quarter of prior recession).  

In each of the four cases, residential investment saw the fastest growth immediately after the previous recession, which lasted up until the beginning of the next tightening cycle (where the pink blocks begin).  However, once interest rates started to rise, economic growth came mostly on the back of personal consumption and nonresidential investment.          

Could this time be different?

So far the script appears to be similar to what we saw in previous expansions.  Private credit growth was shrinking up until the end of 2011, and has expanded at a faster pace since, even after the Fed started to raise interest rates in December 2015 (note that data is available only until Q4 2017).

Housing starts doubled between 2011 and 2015, making up some of the ground lost during the housing crash, but appear to have stalled since then.  It remains to be seen whether the recent downturn in housing starts continues – starts for June were down 4.2% from the same month in 2017, even as May and April data were revised lower.

 Source: FRED.

At the same time, there is a key difference between the current expansion and earlier ones: residential investment is a significantly smaller part of the economy today than it was during the previous four expansions.  The following chart shows residential investment as a share of GDP over the past four decades, along with tightening cycles and recessions.

Source: Bureau of Economic Analysis.

Past expansions saw residential investment as a share of GDP shrink over the course of the tightening cycle and into the recession.  However, residential investment is only 3.9 percent of GDP currently, which is significantly lower than where it was at the beginning of prior tightening cycles.

This raises the question as to whether tighter monetary policy will (negatively) impact the economy in the same way it has in previous cycles.  In other words, if monetary policy largely works through housing, and if housing is a much smaller part of the economy now than in the past, perhaps monetary policy will have less of an impact.

In which case, the power of the yield curve to predict recessions comes into question.  Or, perhaps there is another lurking variable (to use a phrase from statistics), like fiscal policy.  We will explore this in a future piece.

 

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