Growth Cycles Are "Murdered By The Fed": Why Hasn't Fed Rate Hikes Murdered The Current Cycle?

History shows that US growth cycles don't die of old age but are "murdered by the Federal Reserve." Then why has the most significant, in terms of scale, Fed tightening cycle of the past forty years not "murdered" the current growth cycle? The question is complex and challenging to answer, involving many factors. Still, monetary and fiscal policy roles are central to the current growth cycle, making this a compelling study area for analysts and policymakers.

Monetary Policy

The Fed's 500 basis point tightening cycle from 2022 to 2023 stands out as the most significant in scale over the past forty years, surpassing the previous four cycles, which ranged from 175 to 350 basis points. Notably, three of the prior tightening cycles ended in recession, with the 1994-95 cycle being the exception. This time, the economy avoided recession and experienced a growth of over three percent following the Fed's cessation of official rate hikes.

So, has the role of monetary policy in impacting growth cycles changed, or is the policy stance not restrictive to "murder" a growth cycle? The latter.

First, history shows that restrictive monetary policy occurs when official rates are well above the inflation rate. The Fed hiking cycle started with official rates near zero, far below the inflation rate. It wasn't until the middle of 2023, more than a year after the Fed started hiking rates, that official rates matched and then began to exceed what is reported nowadays as consumer inflation.

Yet, it is worth noting that a recent study by economists at Harvard and the IMF found that if inflation was still measured the "old way" (i.e., which included financing costs), reported inflation would have been in the mid-to-high teens. Monetary policy may not be restrictive if actual or experienced inflation is higher than reported. The Harvard and IMF study did not include house prices in its findings as the old CPI did. If house prices replace owners' rents, which are not actual prices, the current reported inflation is still far below actual or experienced inflation.

Economists have developed numerous rules or indicators, such as the Sahm rule and yield curve, to gauge the risk of recession associated with a restrictive monetary policy. However, the housing starts rule stands out for its consistent reliability. It has always succeeded in signaling a tight monetary policy and an impending recession. A substantial decline in housing starts has consistently preceded every recession, and so far, housing starts have not shown a decline associated with stringent monetary conditions. This underscores the importance of considering multiple indicators in economic analysis.

The new tool of quantitative easing is another factor that needs to be considered in the overall stance of monetary policy. Based on the 'stock effect' of quantitative easing, which former Fed Chair Ben Bernanke said is more powerful than the flow effect, QE has offset a significant chunk of official rate hikes, as the Fed balance sheet is still twice the size it was before the pandemic. This underscores the complexity of analyzing the current stance of monetary policy, as the scale of QE needs to be considered.

Fiscal Policy

Fiscal policy is another critical factor when analyzing the current economic cycle. Every dollar the federal government spends goes into someone's pocket, whether a consumer or a business.

The federal government is running a deficit of 6% of nominal GDP. Deficits of that magnitude are rare, occurring during the depth of the recession and never during an economic growth cycle.

When the federal government runs a deficit, it's comparable to when the consumer borrows money to spend beyond its income. Yet, federal government spending is not sensitive to interest rates as it merely borrows more to fund the excess expenditures.

The stance of fiscal policy will only change in two ways: first, if there is legislative action to reduce the pace of spending, or second, if there is a change in tax law requiring consumers and businesses to pay more in taxes to fund the higher spending. Given the 2024 elections are three months away, Congress will not pass any significant spending or tax legislation. And with a new administration taking office in early 2025, it is unlikely that there will be any fiscal restraint anytime soon. The earliest there could be a significant change in fiscal policy stance is when the 2017 tax cuts expire at the end of 2025.

So, when the next recession occurs, it will still be "Made in Washington." However, for now, the combined monetary and fiscal stance policies are too stimulative for a recession to occur and are likely to become even more so if the Fed decides to ease in September.