Another Beautiful Theory Spoiled by Ugly Facts

In an April 16, 2024 Bloomberg News article entitled “What If Fed Rate Hikes Are Actually Sparking US Economic Boom?”, it is argued that the Fed’s increase in the federal funds rate from 0.08% in March 2022 to 5.33% in July 2023, which, in turn, pushed up other interest rates, stimulated US domestic aggregate demand for goods and services by increasing interest income to holders of fixed-income assets. Wow! This novel hypothesis, if valid, turns monetary policy theory on its head.

Let’s look at some data. As can be seen in Chart 1, there does indeed seem to be some positive correlation between the level of the federal funds rate and the level of personal interest income. For example, when the Federal Open Market Committee (FOMC) hiked the federal funds rate from the beginning of 2016 through the first quarter of 2019, personal interest income moved up sympathetically. Although personal interest income had started increasing in 2014, before the FOMC had begun raising the federal funds rate. Similarly, as the FOMC began hiking the federal funds rate in 2022, personal interest income starting rising, too. So far, so good for this hypothesis that FOMC federal funds hikes raise personal interest income.

But, when we compare personal interest income to total personal income, the story changes (see Chart 2). As the federal funds rate increased in 2016 through early 2019, personal interest income as a percent of total personal income moved up only marginally. In the 2022 through early 2024 period, the ratio of personal interest income to total personal income did move up, but only slightly higher than the level that prevailed in 2020, when the federal funds rate was effectively zero percent, and considerably below the 2019 level, despite a much higher federal funds rate in the more recent period. If higher personal interest income were responsible for the recent resilience in aggregate domestic demand, personal interest income as a proportion of total personal income would be higher. Alas, another beautiful theory spoiled by ugly facts.

Let me offer a different hypothesis as to why US aggregate demand has remained resilient in the face of the FOMC’s federal funds rate hikes starting in 2022. This hypothesis was hinted at by one of my readers, Tague Goodhue, Managing Partner at Pantheon Investments, LLC. A year or so ago, Mr. Goodhue observed that although the growth in thin-air credit (the sum of the monetary base and loans/investments at depository institutions) had slowed dramatically, the amount outstanding of thin-air credit remained exceedingly high, such that the ratio of nominal GDP-to-thin-air credit, or the “velocity” of thin-air credit was comparatively low in terms of the period from the recovery of the Great Financial Crisis up until the Covid negative supply shock. This low velocity on thin-air credit implied that the public’s demand to hold rather than spend the resulting liquid assets created by thin-air credit was relatively high. If I had paid more attention to Mr. Goodhue’s observation I might not have made one of the worst calls of my career, including my retirement. That bad call being that a recession would begin in 2023 because of the precipitous slowing in the growth of thin-air credit. I won’t make that mistake again, just a different one.

As I mentioned, the creation of thin-air credit results in the creation of liquid assets. Plotted in Chart 3 are quarterly observations of thin-air credit (the blue bars) and quarterly observations of households’ and nonfinancial businesses’ holdings of deposits (demand, saving and time) and money market mutual fund shares (the red line). As you can see, starting in Q2:2022 through Q4:2024, the levels of thin-air credit and household/nonfinancial business holdings of deposits and money market mutual fund shares are almost equal.

Now, let’s look at the relationship between the private nonfinancial sector’s holdings of deposits and money market mutual fund shares and private Gross Domestic Purchases (private aggregate demand). This is plotted in Chart 4. It is, in effect, the inverse of a velocity concept. As can be seen, as of Q4:2023, the private nonfinancial sector’s holding of deposits and money market mutual fund shares as a percent of nominal private Gross Domestic Purchases remains high relative to percentage levels in years prior to the Covid negative supply shock of 2022. Thus, the private nonfinancial sector as of the end of 2023 still held an abnormally-high amount of liquid assets, assets that could easily be used to purchase goods, services and assets.

As an aside, the data plotted in Chart 5 show that growth in a narrower variant of thin-air credit has picked up in the past two quarters, including its bank credit component. Could it be that the Fed’s monetary policy has eased in the past two quarters despite the fact the federal funds rate has been held steady at 5.33.

In sum, I would argue that the “new” view on how monetary works, namely that higher federal funds rates are stimulative, is utter nonsense. (I was going to use another term, but this is a family publication). Rather, the massive amount of liquidity that the Fed created in reaction to the Covid negative supply shock has not disappeared in either an absolute sense, but more importantly in a relative sense. This implies that the private nonfinancial sector, at least through Q4:2023, still has excess funds that it can use to purchase goods, services and assets.