Monetary policy difficult path forward

ECONOMY & POLICY

January 12, 2024

Chief Economist Eugenio J. Alemán discusses current economic conditions.

We have read plenty of analysis on what the Federal Reserve (Fed) should do as it decides when to start lowering interest rates this year. Much of the analysis is well-intentioned as well as based on very good arguments. However, some of these arguments seem to be based on a presumption of perfect foresight. That is, the analysts who make these arguments seem to feel that they know, with certainty, what is going to happen in the future.

We are a bit humbler when we make our arguments. Although we have a forecast of what we think is going to happen, we never know when and if the economy could throw us a curve ball. And we think the Fed should also remain humble regarding what it believes the future to look like. Many arguments we have heard say that interest rates are too high and keeping them high for too long risks sending the U.S. economy into a recession – even though inflation has come down considerably while the rate of unemployment has stayed below 4.0%.

One of the counterarguments to this issue is that so far, these high interest rates have not done much to slow down economic activity in any measurable way. And once again, we continue to argue that what happened during the last several years was not a typical monetary cycle but fundamentally a fiscal cycle. Monetary policy has not been as effective in slowing down the growth rate of the economy as it would have been had the cycle been created by the expansion of credit, i.e., through the money multiplier.

But even if these higher interest rates have not been able to derail the U.S. economy so far, the effects of higher interest rates have not been innocuous even in this environment, as the U.S. economy experienced several negative shocks from higher interest rates: First, real gross private domestic residential investment declined for nine consecutive quarters on an annualized, quarter- over-quarter basis, starting in the second quarter of 2021 and up to the second quarter of 2023, after which it recovered slightly during the third quarter of last year. However, these declines in real residential investment were not able to derail the overall economy.

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Second, the U.S. economy faced the possibility of a full-fledged banking and financial crisis at the beginning of 2023, as several banks experienced runs due to bad investment decisions while revealing important mismatches in other banks due to the strong increase in interest rates and the decline in the market value of Treasurys held by banks. However, the Fed and other regulatory agencies moved fast to backstop these runs and give certainty to the financial markets, and the economy, thus far, has avoided the potential consequences of these higher rates. Third, borrowing has become extremely expensive, as mortgage rates surged to almost 8% in 2023 and are now hovering below 7%, while interest rates on credit card borrowing have continued to skyrocket to the highest level since at least 1994.

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However, the lack of supply of homes has kept the housing market relatively strong even in the face of such high interest rates, while the strong performance of the labor market seems to have given consumers plenty of reasons to feel invincible and to continue to splurge, – even if it meant borrowing and consuming by using such an expensive credit alternative.

Furthermore, any one of these issues could resurface once again, especially if interest rates remain at these levels for longer periods. For us, the conditions of the housing market are problematic and the mismatch in the balance sheet of banks may be important. However, the biggest issue for us is the cost of credit card borrowing, especially if the U.S. enters a recession and jobs start to be lost. We think that credit card borrowing could become the most important risk for the U.S. economy going forward, and we are concerned that even current interest rates have not been able to curb the growth in this segment of credit.

This means that we also are concerned that keeping interest rates high for too long could have negative effects on the economy. However, we are concerned that if the Fed starts lowering interest rates too early and a new monetary cycle begins, the disinflationary process may come to an end. And the Fed still has an inflation target to hit, which is 2.0% over the longer term for the Personal Consumption Expenditures (PCE) deflator. And, as we have written clearly in the past, the Fed is not about to change its inflation target in the middle of the game, either for those who believe that a different (higher) inflation target is better or for those who believe that structural issues will prevent the Fed from achieving its 2.0% target.

For an institution that has set an inflation targeting mechanism, not hitting the target or changing the target in the middle of the game means failure and could negatively affect inflation expectations. And we think the Fed is not ready to do that any time soon.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023