Following the financial crisis I was very vocal that lower interest rates and QE would not cause high inflation. This went against the prevailing theory that lower interest rates and more reserves in the banking system could cause a surge in bank lending as lower rates make loans more affordable and more reserves give banks more ability to “multiply” loans. The reason this wasn’t true was because the USA was in a specific type of recession called a balance sheet recession in which households were paying down debts following a huge credit boom. This meant that there was very little demand for debt and so increasing the supply of potential loans was like an apple cart salesman increasing the number of apples he sells with the hope that more supply would create its own demand. But the problem was that the demand for apples was structurally low. Further, we now know that reserves have only an indirect linkage to loans. Banks do not “multiply” their reserves because banks quite literally cannot multiply their reserves (more on that here if you’d like to get into weeds on that).

Following the financial crisis it became very popular to say that Monetary Policy (including interest rates) had limited or no impact. Now, I think it’s important to make a distinction here. QE is an asset swap as I’ve explained many times in the past. From the perspective of households it takes a bond out of the private sector and exchanges it with a deposit. This is akin to changing a savings account into a checking account. The reason this doesn’t have a huge impact on inflation is because there’s no reason for consumers to materially change their spending patterns just because they change a safe high yielding asset into a safe low yielding asset. In fact, because QE reduces interest income it might have a marginally deflationary impact on the economy, all else equal.

Interest rates are different and have a much more meaningful impact on the economy by impacting banks and credit markets. This is not necessarily true in a balance sheet recession, but it’s different in an environment like the current one where demand for credit is otherwise healthy. This has been quite clear in the last year or so as credit demand has declined sharply as rates have risen and we’ve seen banks under pressure. Despite this, there are still some circles of the economic world that claim Monetary Policy has no impact or stranger yet, some say higher rates actually push inflation UP. Let’s study the operational underpinnings here as well as the evidence.

First, higher rates work thru many different channels including:

  1. The credit channel. This works by making credit tight and making it harder for consumers to borrow. This has clearly occurred in the mortgage and auto loan markets and we’re even starting to see it rolling into consumer credit.
  2. The wealth effect. Higher rates put downward pressure on asset prices, especially bonds. This has been clearest in the bond market where American bond investors have unrealized losses of $5 trillion in the last two years.

There are several other channels described here, but these are the most obvious ones from recent experience. Let’s now turn to this idea that higher rates might be putting upward pressure on inflation and demand.

  1. The only people who say interest rates have had no material impact on economic growth are Americans. If we look at the case of Canada and Europe, for instance, they’ve followed nearly identical interest rate policies in recent years and both are on the verge of recession. It’s actually a strange narrative in the USA where real GDP has averaged just 2.2% since the Fed began raising rates. Meanwhile, we’ve had a rolling bank panic and a significant decline in credit growth. Unsurprisingly, inflation has fallen all the while. Still, when we study out of sample tests the rest of the world tells a very different story from the USA. Still, I’d argue that even in the USA we’ve seen the impact in slowing employment growth, slowing wages, slowing RGDP, slowing credit growth and most importantly, slowing inflation.
  2. Interest rates put pressure on financial assets. Finance 101 teaches us that interest rates cause financial asset values to change. When the Fed raises the risk free rate you’ll get a short-term decline in bond values, for instance. In the case of the global bond market we’ve seen a $10 TRILLION decline in value since the Fed began raising rates. In the specific case of the USA you’ve had a $5 TRILLION decline in bond values. So, if you owned $100 worth of bonds yielding 2% in 2022 you now own $90 worth of bonds yielding 5%. Are you better or worse off? Clearly, you’re worse off even though your expected future income has increased.
  3. Is the national debt and rates exposing us to a period of “fiscal dominance”? Some heterodox theories claim that fiscal policy is now putting upward pressure on rates because the national debt is so large that higher rates cause larger deficits. Since the Fed started raising rates in 2022 the annual interest burden on the national debt went from $635B to $1,025B. So the US government is paying out an extra $390B per year in interest. That’s enough to drive demand higher a bit, but the problem with that narrative is that, out of the $34 trillion in national debt $12T is held by the Fed and other government agencies. And another $8T is held by foreign governments. The remaining domestic holdings are $14T. This means 41%, or $420B is being paid out to the domestic private sector annually. That’s a $200B increase over the $220B that was being paid out to the private sector in 2021 before rates shot up. Not nothing, but also not enough to move the needle of a $30T economy. 1
  4. Rates have a disproportionate impact on consumption. Most of the bonds held by the domestic private sector are held in retirement accounts and by wealthy investors with a low marginal propensity to consume. Further, when credit tightens this tends to impact consumers with a high marginal propensity to consume as they’re the ones who rely more on revolving credit to spend. Total credit growth has slowed to just 2% in recent years. What all of this means is that wealthy people are getting more interest income and saving it while poorer people are locked out of credit markets. In total, this leads to slower consumption as the rate impact hurts the middle class and those with a higher propensity to consume.
  5. Rates have a disproportionate impact across time. I enjoyed this recent post by David Andolfatto on this subject. His conclusion was basically “higher rates put downward pressure on the economy in the short-term and establish a new higher equilibrium if held there in the long-term” (my summary, not his exact words). That makes a lot of sense to me and the best way to understand it might be bonds. Going back to our previous example – the consumer who held $110 in the Bond Aggregate in 2021 was earning 1.5%, but now holds $98 of bonds earning 4.3%. If we assume rates won’t change in the future then it will take 3 more years for this investor to break-even. So the rate hike causes a 5 year short-term disruption to this person’s balance sheet and income statements, but after year 5 the higher rates will start to benefit this investor. And it’s not until year 7.5 that this investor is better off than the counterfactual where he held the 1.5% yielding bonds and rates never changed. So this investor is materially worse off in the short-run even though he’s now earning a much higher interest rate. And I haven’t even included inflation in these figures. This is the basic math behind what’s happened to every consumer who owns these bonds.

The bottom line is yes, higher rates could be stimulative in the long-run, but as we’ve clearly seen in the consumption and inflation data, higher rates put downward pressure on growth in the short-term. The interesting question for now is “what is the short-term” because the longer the Fed keeps rates high the more we’ll see interest rate sensitive instruments impacted in a negative manner. It’s been only about a year since credit turned tight so if our long-term is 5-7.5 years, as our example above showed, then we’re still very much in the short-term impact period of rate hikes.

1 – Some post-keynesian and MMT advocates have stated that higher interest rates didn’t work because we’ve seen no material change in employment. Aside from being untrue, this is also the wrong metric from which to gauge this. Heterodox economists know that there’s little to no correlation between employment and interest rates. They’ve been some of the most vocal people who reject the Phillips Curve theory. But they’re now suddenly saying employment reflects the impotence of rate hikes. This makes no sense. Besides, we’ve clearly seen hourly earnings and the rate of employment gains slow. The fact that these metrics aren’t negative does not mean the rate hikes aren’t working. In fact, it might mean they’re working even more efficiently than expected if they’re bringing down inflation without hurting the labor market excessively.