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Good morning! The discussion around higher real bond yields continues on Wall Street. How long can they coexist with a robust economy? As we enter the second quarter earnings season this week, this question will be on everyone’s mind. Pepsi will report on Thursday, followed by several major banks on Friday. Expectations are that S&P 500 second-quarter earnings will show a 7% decline compared to last year. However, with the vibrant economic background, we wouldn’t be surprised if the actual numbers exceed expectations. We’re not in the business of betting, but we’re interested to hear your thoughts: [email protected] & [email protected].
Why is the economy not responding to rate increases yet? The Federal Reserve raised rates by 500 basis points in just 14 months, yet we see that the growth is still performing well. While the economic slowdown is not significantly delayed, there is growing concern about its timing and why it hasn’t shown any signs yet.
The most plausible explanation is a delay, rather than a complete absence of impact. The current lag in policy effects is not unusually long when compared to historical standards. Don Rissmiller from Strategas describes it as “holding our breath underwater, as long as [monetary] policy remains restrictive.” However, this duration is long enough to consider some reasons why this cycle might be different. Here are five possibilities:
1. The neutral rate, which is the real policy rate that doesn’t lead to inflation or hinder growth, might be higher now. Although measuring the neutral rate is challenging, there are indications that it has risen since the pandemic. The New York Fed estimates it to be around 1%, but a recent paper by economists at Vanguard suggests it could be closer to 2%.
2. The $1.5tn fiscal deficit may have caused the neutral rate to rise. Sustained fiscal shortfalls increase the demand for borrowing across the economy, leading to higher nominal interest rates.
3. The global fiscal impulse, which was necessary to revive the global economy after Covid, may have put an end to a decade of secular stagnation.
4. The “savings glut” driven by global imbalances and current account surpluses in emerging countries like China and advanced economies like Germany, is subsiding.
5. The demand for additional borrowing by developed-market governments is expected to increase due to factors like defense budgets, green investments, energy independence, industrial policy, and supply chain optimization.
The labor shortage could be another reason why rate hikes have not had a significant impact on employment. Without an increase in unemployment, it is unlikely for the economy to enter a recession. However, a structural shortfall in the labor supply, coupled with the challenges faced by companies in finding workers during Covid, could be leading to labor hoarding. The “jobs-workers gap” is at its widest on record, indicating the difficulty in matching available jobs with workers.
Debt has been structured with longer maturities in recent years, which means higher rates have a lesser economic impact than before. This is true for both consumers and corporations. The reduced proportion of adjustable-rate mortgages and the surge in mortgage refinancing while rates were low have minimized the impact of higher mortgage rates on household interest costs.
Under the “ample reserves” regime, monetary policy transmission is diluted. Quantitative easing has made money abundant, reducing the urgency for banks to offer competitive deposit rates. This has allowed net interest margins to remain healthy and lending to continue growing.
Additionally, modern services-based economies like the US may be less affected by rate increases compared to investment-led economies like China. The US economy, driven by consumption, tends to experience less volatility. The stability of consumption, combined with advancements in technology and employment tools, has resulted in a smoother path to economic growth.
While these explanations offer insights, it is essential to thoroughly consider them before fully endorsing any. Moreover, even if these factors delay or lessen the impact of monetary policy, it raises the question of whether it increases the likelihood of a soft landing with lower inflation and no recession.
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