Households' Extraordinary Cash Holdings Will Thwart Fed Tightening

By all indications, the Fed will raise the level of the federal funds rate, currently 0.08%, by 25 basis points on Wednesday, March 16. This will likely be the first of series of Fed rate hikes this year. (As this is being written, March13, the 12-month Federal Funds futures contract has priced in a rate of 1.87%. Later in this commentary I will explain why I do not believe the Fed will hike this much in this time period. When Fed Chair Powell is replaced by the reincarnation of Paul Volcker, then we will see more aggressive federal funds rate increases.) Two years ago, when Covid began spreading here, the federal government began handing out money to the bulk of American households, whether or not their incomes were adversely affected by Covid. Where did the federal government get this money to hand out? A lot of it came from the “printing presses” operated by the Federal Reserve and the banking system. And households still hold a lot of this Covid money. This means that as households face rising prices for essentials such as food and gasoline, they will be able to rundown their cash holdings to pay the higher prices without having to cut back on their purchases of discretionary goods and services as they otherwise would. These excess cash holdings by households will blunt the effects of the initial Fed rate hikes.

The red bars (mass) in the chart below represent the sum of currency, plus checkable deposits plus money market fund shares held by households. These cash holdings skyrocketed beginning at the end of Q1:2020. The blue line in Chart 1 represents this cash held by households as a percent of their after-tax income. This ratio also has skyrocketed, reaching a post-World War II high of 154% by Q4:2021. Think of the blue line as the inverse of the velocity of money.

This extraordinary amount of cash being held by households is quickly losing its purchasing power due to high and rising inflation. Other than Treasury I-Saving Bonds (check them out at treasurydirect.gov), there is no place households can invest this cash for a risk-free return equal to the inflation rate. So, I expect that households are going to activate their idle cash balances to pay the higher prices of essentials and, to a lesser extent, the higher prices of discretionary goods and services. Thus, the Fed is going to hike the federal funds rate by 25 basis points several times and will not observe a significant slowing in the growth of nominal consumer spending.

So, why wouldn't the Fed then increase the magnitude of its interest rate increases? Although growth in consumer nominal spending might remain relatively strong, growth in real production of goods and services will slow because of the negative supply shock emanating from Russia's invasion of Ukraine. Typically when the Fed observes a slowing in real economic growth it thinks “lack of aggregate demand” even if it is due to a lack of aggregate supply. Thus, the Fed either stops raising interest rates or cuts them. How unpatriotic would the Fed appear to be by raising interest rates in an environment of national emergency and slowing growth in real production? No, the aggressive Fed interest rate increases will have to wait until this national emergency has subsided and higher inflation expectations are embedded in household and business psyches.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.