In Sunday School Macroeconomics 101, they tell a story about the Fed.
When Uncle Fed cuts rates, it stimulates investment and the economy goes boom! When Uncle Fed raises rates, investment struggles and the economy goes bust. So if you just watch Uncle Fed, you don’t need to bother with all those other complicated macro variables. Isn’t that lovely?
You’ll read versions of this in The Economist, newspapers, investment research, etc. etc. The Fed drives investment, which drives the economy. Simple, tidy, obvious…
The story is not, however, supported by actual data on investment – Net, Gross, or Real Investment as a percent of GDP. I’m not sure exactly what the data below DO say. But they definitely DO NOT say “the Fed Funds rate clearly drives real economy investment behavior.” The two other data series at the end give us different charts telling the same non-story.
Net Business Investment as a Percent of GDP (Left Axis) and Effective Fed Funds Rate (Right Axis)
If the Fed were as powerful as many believe, Big shifts in the Fed Funds rates should drive visible shifts in the investment rate.
- …the last two decades of ever-lower low interest rates should have produced an investment boom. Companies should have been throwing dollars at all sorts of low-return project with rates nearly at zero and Real inflation-adjusted Rates below zero.
- …the 1980’s, should have seen investment struggle in the face of the Volker’s bold rate rises. Those huge rate hikes should have sparked a huge fall-off in investment.
- …the 1990’s should have seen a spike up in investment when rate were were low early in the decade and declining investment as the Fed raised rates later on.
None of these things happened. These patterns just aren’t there. Even if you assume all sorts of lag effects, the two trend lines don’t really connect. If there is any pattern, it would be the Fed Funds rate chasing investment downwards. Or vice versa…?
If low rates really drove behavior as much as the Fed fans believe, how do you explain what we DO know.
- The Fed WAS powerless under ZIRP before COVID. That’s why they came up with side show distractions like QE. The Fed was at the zero lower bound and struggling to re-start the economy.
- A lot of people have forgotten that sluggish, “pushing on a string” pre-COVID economy. We had a decade of super low rates in the 2010s AND also a decade of super low private capital and public infrastructure investment.
- COVID gave us all a sharp lesson in just how powerful fiscal policy is. Shocking the economy into higher inflation and super-strong employment after a decade of monetary policy “pushing on a string.”
- Investment today has not, so far, responded to higher rates by going down. Anecdotally, its been going UP (boosted by Government policy and lot of other “its complicated” cross-currents.
- Studies showing corporate investment “hurdle rates” don’t change (much) in response to interest rate changes.
I’m not sure how to explain the above myself. Maybe the free market out there in the real economy is driving real long term rates drives rates more than people want to believe? Maybe the Fed rate and investment aren’t really linked at all? There are a lot of other drivers out there (e.g. Software isn’t counted as “investment” in these data series).
What we DO know is “investment” is a lot more complicated than a single number emerging from Washington DC. So we know we don’t have a simple, one-factor trade…
Faced with the complexity above above, I see/read/hear a lot of people doubling down on simplicity. If the Fed can’t cause a recession with hikes to 5%, then it dang-gummy must keep raising to 7%! Because we must have a recession! Because… why?
Maybe the real impulse is just so “we” can keep clinging to our prior beliefs? Simple rules that comfortably explain a complicated world. A craving for certainty…
Maybe a recession is the price some think we “must” pay simply to keep our world-view intact? Doubling down on the same experiment until the results support the belief…
Maybe abandoning that narrative would mean giving up belief in God Santa Claus? Losing the monotheistic comforts of a benevolent Holy Father Fed. Fearing a polytheistic world of multiple, erratic, uncontrolled Gods indifferent to the petty struggles of humankind.
I’m not sure. Its complicated…
I try to live in the complicated middle ground between “the Fed is powerless“and “the Fed is a one-factor driver of the economy and all you need to follow.”
That middle ground is neither simple nor tidy nor obvious. “The Fed is a powerful actor, but not nearly as powerful as some people think. The real economy runs the show. The Fed is just well-intentioned humans feeling their way along like the rest of us. Their tools are limited and the effects unclear. If the data are confounding, they are as stumped as we are.”
I got to that middle ground in the last decade. The Fed was pretty obviously powerless pre-COVID. Even The Economist had to admit that. The last 18 months hammered that relative impotence home. After 5 points of rate rises we can pretty confidently conclude “the Fed ain’t nearly as powerful as some people wanted to believe in early 2022 or, really, since about 1990 when the “Volker myth” was created (with remarkably little empirical support).” If the 2010’s didn’t convince you, the last 18 months should have been evidence enough.
“No-one” expected rates would rise this far. The few that did were forecasting rapidly rising unemployment and a huge recession. I certainly didn’t get it right myself. So the right response is to accept that your prior, simple mental models were wrong. Take a step back and look at the bigger, more complicated picture. Even if it doesn’t make tidy sense.
Gross Business Investment as a Percent of GDP (Left Axis) and Effective Fed Funds Rate (Right Axis)
Real Business Investment as a Percent of GDP (Left Axis) and Effective Fed Funds Rate (Right Axis)
