Three reasons why the FED’s monetary tightening did not trigger a us recession

According to the famous words of Milton Friedman¹ , often cited by central bankers, “There is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable.” Central banks’ econometric models generally find that the effects of changes in key rates show up in the economy with a lag of 12 to 18 months. Christine Lagarde recently even suggested a lag of 18 to 24 months. Accordingly, as the Fed’s most aggressive tightening came in the second half of 2022, its cooling effects on the economy should show up mostly in the second half of 2023 and in early 2024.

While the effects of the Fed’s monetary tightening will take time to show up, that lag has (at least, temporarily) been mitigated by its massive 2020-2021 easing cycle. In March 2020, the Fed cut its key rates by 150 bps, at the start of the Covid crisis, and then followed that up with a massive QE cycle. Keep in mind that the Fed was still buying up Treasuries and MBS in early 2022! One of the big consequences of its easing policy was a wave of mortgage refinancing that was overwhelming in both its extent and its duration. Millions of households refinanced their mortgages at very low fixed rates in 2020 and 2021. The 2022-2023 monetary tightening cycle has therefore not affected them much, the main impact being a strong disincentive to move to a new home (selling their current home to buy another would require financing at far higher rates).

Lastly, the aggressive 2020-2021 Fed easing, combined with other factors, provided a big boost to household wealth, including real estate and stock market prices. These wealth effects have lasted, as real-estate prices have slipped only slightly and equity markets are far above their pre-Covid levels.
The effects of the 2022-2023 Fed tightening cycle have been mostly dulled by the 2020-2021 easing cycle.

Monetary tightening was, of course, expected to dampen economic activity, but US fiscal policy has been working in the opposite direction. The first two years of Biden’s term have been marked by at least three very ambitious investment plans:

• The bipartisan Infrastructure Investment and Jobs Acts, (IIJA), passed in November 2021, with its estimated $550bn in new spending over five years;
• The economic decarbonation plan, called the Inflation Reduction Act (IRA), passed in summer 2022, with about $440bn in estimated new spending (some estimates put this three times higher); and
• Semiconductor investments (the CHIPS and Science Act), also passed in summer 2022, under which new spending has been estimated at $280bn over 10 years.

Some estimates of spending under these programmes are fuzzy – for one thing some of their tax credits are not capped – and that makes it difficult to have a precise idea of these plans’ impact on economic growth. However, it is clear that investment in industrial infrastructures has risen sharply – by 63% in real terms over the past 12 months! Investment in manufacturing facilities accounted for more than 0.4 percentage point of the 2.1% of growth in Q2. More importantly, this share has risen steadily in recent quarters. Investment has been especially heavy in IT, electronics and electricals. To cite two examples, investments in semiconductors has been boosted by CHIPS Act incentives, and those in electricals by tax credits by the Inflation Reduction Act. Incidentally, this shows how much investments in long-term themes (e.g., the energy transition and economic sovereignty) can support economic growth today.

Another source of support for households was the suspension of student debt repayments since March 2020, which will end in September (for interest payments) and in October 2023 (for the principal). The suspension has preserved the purchasing power of tens of millions of households for three and a half years and has cost hundreds of billions of dollars. The resumption of student debt repayments will inevitably undermine purchasing power.

Meanwhile, payments under Social Security (public pensions and benefits for disabled people) rose by 8.7% in January, their steepest increase in 40 years. This helped preserve the purchasing power of the more than 65 million Social Security beneficiaries. More broadly, the ageing of the population (along with higher pensions and healthcare costs) had put the public deficit on an upward trend even before Covid. This has been an underlying source of support for US growth over the past 10 years.

Another big reason why the sudden tightening in monetary policy has not triggered a recession is that households have held a huge amount of the excess savings that they had piled up during the Covid crisis. In theory, higher interest rates produce more stringent credit conditions – commercial banks are more reluctant to lend, and households are more reluctant to borrow. This is supposed to dampen consumption, as some household consumption is on credit. This channel has worked far less well in this cycle than in the past, as households on average have had far less need to borrow… because they had accumulated large excess savings in 2020 and 2021. Use of this excess savings allowed them to cope with a surge in inflation with no major economic hiccough. Accordingly, and while estimates are not precise, excess savings are believed to have peaked at $2100bn (in late 2021), with still $500bn left over in July 2023. The more time passes, the more that excess savings will continue to shrink and the more that the traditional channel of transmission of monetary policy via interest rates will work as expected in theory. Households will then have to adjust their consumption to their incomes.

Despite the Fed’s aggressive monetary tightening (its most hawkish in 40 years), there has not (yet) been a recession in the US. There are three main reasons for this:

• The sudden shift to monetary tightening comes in the wake of monetary easing that was just as aggressive and the effects of which continue to show up;
• Monetary tightening has been thwarted by an especially expansionary fiscal policy;
• Excess savings built up during Covid have delayed the traditional transmission of monetary policy via interest rates.

A number of supports for growth will gradually vanish – the effects of the 2020/2021 monetary easing will fade away; repayment of student debt will resume; budget negotiations are likely to be tense; and excess savings are likely to have been used up by yearend.

1. Milton Friedman, 1960, « A program for monetary stability »