The economy continues to grow as pent-up demand outstrips the Federal Reserve’s excessive increases. Why is the economy doing well in the face of the fastest increase in interest rates in history? The answer is pretty simple, and it is why the economy will continue to grow.
Dr. Peter Linneman
First, there is pent-up demand for lots of items, most notably autos. As we have previously written, the U.S. has under-consumed both autos and housing for more than a decade. Additionally, non-covid medical care was deferred during the first two years of the pandemic, and people are still catching up, particularly when it comes to elective procedures. The same is true for travel and tourism, which is on par with where it was in 2019. That is a big recovery from the previous three years. However, it is nothing special in the longer-term view because we are merely catching up on the 2 percent annual growth that we should have seen since 2019.
Second, most of the U.S. economy (80 percent) is not sensitive to short-term interest rates. For example, changes in the short-term rate have almost no impact on government jobs, healthcare jobs or output, which combined represent about 53 percent of GDP. In contrast, sectors that are sensitive to short-term interest rates (e.g., banks, manufacturing, and entrepreneurial development) account for perhaps as little as 20 percent of GDP. Thus, the Fed’s attempt to fine-tune the entire economy by changing interest rates is a very limited way to conduct policy because the intended slowing must be generated almost completely through a mere 20 percent of the economy.
Financial factors
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The main sector that is affected by the Fed’s short-term interest rate policy is finance, and regional banks in particular, as they do not have massive reserves. Regional banks operate on the spread between short-term and long-term interest rates, so when the yield curve inverts, that spread disappears. With the short-term interest rate about 200 basis points too low, the Fed has single-handedly put many regional banks in an untenable position. As the Fed brings short-term interest rates down, regional banks will strengthen.
A third reason that the economy is doing well despite the Fed’s interest rate policies is that individuals and corporations locked in long-term money from 2020 through early 2022. So when interest rates kept rising, the increases had very little effect on households. As we have reported, about 42 percent of all American households locked in home mortgages that were very cheap by any historic standard. To state it differently, they have effectively secured in 5 percent to 10 percent increases in their disposable income. Notably, locked-in home mortgage rates will give a boost to the multifamily sector because existing homeowners will be disinclined to sell.
Similarly, many multifamily owners have locked in Freddie Mac and Fannie Mae loans at record low rates for seven to 10 years. Many corporations are also benefitting from long-term, low-rate debt. In short, these locked-in rates have done much to make the economy interest-rate insensitive and shield it from the Fed’s misguided monetary policies.
Dr. Peter Linneman is a principal and founder of Linneman Associates and professor emeritus at the Wharton School of Business, University of Pennsylvania. www.linnemanassociates.com
Follow Dr. Linneman on Twitter: @P_Linneman
Read the November 2023 issue of CPE.
