The rates are coming home to roost
Why monetary lag suggests the worst is yet to come
I suspect that monetary lag is a concept we’re going to hear about a lot more in the coming months. If you prefer a fancy definition you can go to Investopedia, but if you’re content to trust your humble narrator here’s how I would put it. Monetary lag references the fact that changes to monetary policy can take up to a year to have the desired impact on the real economy.
As it concerns our current situation we’re only just now starting to experience the full impact of the Fed’s near historic rate hikes. Don’t take my word for it either, here’s what Jay Powell said in a speech in November.
Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt.
As such, analysts who claim that higher rates are already priced in, or the worst is already behind us, are likely* to be proven wrong throughout the rest of this year.
*There is never certainty in markets, and so far the bulls have been winning handily.
What causes monetary lag
Higher interest rates are intended to make borrowing more expensive, which should reduce demand for goods and services and put the brakes on economic activity. We could elegantly summarize the effect as: we’ll make the peasants so poor they can’t afford to buy anything and thence there shan’t be any inflation.
Interest rate induced poverty is all fine and good, but people don’t become poorer overnight. It takes a while before you can’t afford breakfast. Hundreds of thousands (millions?) of homeowners refinanced their homes when interest rates were at all time lows in 2020 and 2021. Domestic savings rose and corporations borrowed money on extremely favorable terms. By and large, citizens and conglomerates were financially secure when the Fed started hiking rates.
Unfortunately, we’re now reaching the point where the savings are running low, corporate treasuries are looking anemic and credit is no longer easy to come by.
How monetary lag can crush the markets
Monetary lag is pernicious because it plays on a vulnerable aspect of our psychology. As humans we’re predisposed to recency bias. If something is predicted to occur, but never happens, we tend to believe it won’t occur.
So many analysts have warned that higher rates would headshot the financial system and bring the stock market to its mud-caked knees, yet the SPX is at 4,100 halfway through February of 2023! And every time it seems like the market is about to crash, a miraculous rally has stepped in to save the day.
The net effect is that market participants have been conditioned to believe that after all these bearish predictions have been nullified, nothing bad is going to happen in the future. I would speculate that central bankers are not immune to recency bias either. Jay Powell had the audacity to jack rates up sky high and instead of blowing the financial system to kingdom come, everything appears to be OK. Even though Powell is aware of monetary lag, there must be a part of him that believes he’s drifted the economy in for a soft landing.
Or has he..? The trouble is that we’re reaching the point where corporations need to refinance, and it’s not just a handful of businesses either.
Western economies are littered with zombie companies that can only stay in business by tapping the debt markets. Michael Howell has pointed out that we no longer have a “financing” system so much as a “refinancing” system. Collectively we rollover a hell of a lot more debt than we originate.
The problem for our economy is that to the extent that higher rates squeeze the financial system and reduce balance sheet capacity, zombie corporations might not be able to secure financing. That means bankruptcies and all sorts of other uninspiring economic calamities.
I’m extremely sympathetic to the argument that these zombie companies should go out of business so we can regain some economic vitality. However, a wave of bankruptcies is easy to read about in a textbook but difficult to live through.
Look at that Tweet: 40% of companies in the Russell 2000 are at risk! If these corporations start to go belly up we’ll probably all know someone who is affected.
What affects the speed of monetary lag
The time delay on monetary lag is not an exact science. While analysts commonly call for a 6 to 12 month lag, several factors dictate the speed at which monetary policy works.
Centralization. The more centralized the banking system, the less monetary lag. For example, Chinese financial regulators have tight control over the domestic banking system and they can quickly force the banks to increase or decrease their lending. In western democracies the banking regulators don’t have as much control, so monetary policy is slower to diffuse through the system.
Competition. Having less competition may decrease monetary lag. If the banking sector is an oligopoly the big banks can all agree to raise borrowing rates in sync. If there are multiple banks competing for customers, the competition may keep lending rates lower for longer.
Intermediation. Are banks holding most loans, or are loans being repackaged and sold off as asset or mortgage backed securities? The more that banks hold loans on their books, one might expect monetary lag to decrease as banks quickly raise lending rates since they’re taking a risk.
That’s all folks
We’re entering the danger zone for monetary lag. If these rate hikes are going to catch up to us it’s going to happen sooner rather than later. On my end I have a slightly contrarian opinion.
Instead of raising rates to dismantle demand, if I was economic dictator I would have kept rates lower and addressed the structural issues that have encouraged inflation. Fix our supply chains, update the infrastructure, invest in energy production, make lockdowns illegal so we never see that catastrophe manifest again, etc. Focus on the supply side of the supply/demand equation.
However, I think Powell lost my phone number because I never got his call.
On that cheery note I’ll bring this article to a close. Could we get the soft landing and everything is Lamborghinis and grandma’s apple pie? Sure! Is it likely? I would say probably not, but only time will tell.
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Great stuff.
First time reading, we like your work man!