How To View An “Insulin Resistant” Economy
When the Federal Reserve reduces interest rates, we assume economic growth will improve significantly. But what if the direct economic benefit of monetary easing weakens? Just as a body can become resistant to insulin’s power to convert blood sugar to energy, monetary policy’s ability to generate major new spending can weaken as the cycle progresses. While rate cuts may not become completely ineffective, we probably should view the Federal Reserve’s recent policy actions a little differently.
Why Rate Cuts Become Less Effective
Monetary easing has its greatest impact when it unleashes a backlog of spending. That usually happens early in an economic cycle, after higher rates and economic contraction have kept spending below the long-term potential for a substantial time. As the cycle progress and the backlog is reduced, however, that ability to spur a large surge of spending erodes.
After backlogs are worked down, however, rising capacity utilization can also drive growth. Yet on that score, the current cycle has been disappointing. Capacity utilization has remained low, and many businesses report intense competitive pressures. That seems to have dampened enthusiasm for major capital investments. Normalized for the level of economic activity, businesses have invested far less in capital projects over the last ten years. Tight labor markets have prompted a rise of spending on productivity-enhancing technology (see the work of Cornerstone Macro), but the weak need for general expansion suggest overall capital investment may not respond strongly to lower rates.
Finally, monetary easing should have a stronger effect when rates hit new lows for the cycle or when lending standards ease markedly. Yet short-term interest rates were lower not that long ago. And long-term rates have stayed comparatively low and loans have remained easy to obtain. Under those conditions, a minor easing of short-term rates should have a comparatively small impact on most business and consumer spending.
An Economic Placebo Effect
Monetary easing, however, does more than simply provide consumers and businesses access to funds. It also provides the confidence to spend. At times, in fact, the public’s expectations of what monetary easing will do for the economy may be more important than the actual spending it generates. In medicine, patients frequently respond to “placebo” treatments as if they had actual medicinal value. In the economy as well, public confidence in monetary easing may help sustain economic growth even if lower rates generates little in the way of new spending.
The effect of easing on public confidence should be especially important when the economy is just starting to slow. As the public begins to worry about a sharp slowdown, if consumers and businesses are reassured before they stop spending, the economy stands a much better chance of avoiding recession. Particularly given the dominance of consumer spending within the economy, consumer reassurance goes a long way toward keeping the economy moving forward.
A number of indicators suggest the Fed’s three rate cuts calmed many of the public’s fears about recession. Equity prices broke to new highs. Higher long-term interest rates indicate growth expectations have risen. And sentiment surveys showed signs of improved confidence among businesses and consumers.
Yet improved confidence may not in and of itself generate significantly more growth in the short run. Consumer have spent at a healthy clip in 2019, in line with income gains, which indicates relatively little potential for a major rebound. And while improved confidence may help stem the decline in industrial activity, which would add to overall GDP growth, the industrial decline reflects international weakness as well as concerns about the domestic slowing. A significant industrial recovery, therefore, may not occur until global conditions also improve.
Normally it takes the better part of a year for the full impact of rate cuts to hit the economy. It thus remains to be seen how much additional growth the 2019 rate cuts will generate. Given the tightness of labor markets, however, it might be better if the rate cuts had a muted effect on the economy. Rising participation rates and improved productivity have allowed the labor supply to keep pace so far, but GDP growth much above 2.5% would likely put heavy pressure on labor availability and wage rates.
To this point, therefore, it appears the Fed’s prescription for the economy has been effective. Confidence seems primed to keep the economy growing, but growth has remained at levels the labor supply could sustain. While growth of 2% to 2.5% seems anemic by historic standards, this expansion may have a significantly longer run if the economy does not respond too strongly to the 2019 rate cuts.