In his 1961 research paper called “The Lag in Effect of Monetary Policy,” Milton Friedman concluded that “monetary actions affect economic conditions only after a lag that is long and variable.” Based on the fast and steep FED policy rate tightening over the past year, a school of thought pondering short lags i.e. between 4 to 6 quarters after lift-off, became a consensus expectation. Short lags were expected given the anticipatory pricing by financial markets, leading to accelerated tightening of financial conditions. However, a broad set of economic indicators has shown sticky behaviour. Whilst demand-supply conditions across good sectors have more or less balanced out, service inflation rates, supported by robust labour market readings, will prove to buckle with longer lags and express more variability.
Today, it might be useful to revisit research papers that include data series well before the 2008 GFC recession. Research piece was published in a December 2013 edition of the International Journal of Central Banking under the title “Transmission Lags of Monetary Policy: A Meta-Analysis” by Tomas Havranek and Marek Rusnak, researchers at the Czech National Bank. Collecting 67 studies they come to the following conclusion: “The average transmission lag is 29 months, and the maximum decrease in prices reaches 0.9% on average after a 1% hike in the policy rate. Transmission lags are longer in developed economies (25 to 50 months) than in post-transition economies (10 to 20 months). We find that the factor most effective in explaining this heterogeneity is financial development: greater financial development is associated with slower transmission.“
Adding 29 months to the March 2022 lift-off takes us into the summer of 2024 for the hiking cycle to fully impact. In the words of Arthur Conan Doyle, “Patience, my dear friend, patience! You will find in time that it has everything to do with it.” Now, patience is what markets have been lacking dearly, notwithstanding many reversals that have occurred. We have witnessed and observed reversals in headline inflation since H1 2022. Residential real estate investment, i.e., new one-family houses sold, topped over H1 2020 and are currently at near the 60-year average around 670k. US job openings made a high of 12 million+ over March 2022, drifting to 10.8 million at the end of January 2023. The 20-year average sits around 5.2 million job openings. US unemployment ended at 5.936 million at the end of February. The unemployment rate rose from a 54-year low of 3.4% to 3.6% in the latest non-farm payroll series. Clearly, job openings still exceed job seekers. Yet, the ratio between these two can (and most probably will) mean-revert fast. The message is not to underestimate the FED in their resolve to quell demand. Nonetheless, do not underestimate bond markets to anticipate the next accommodation cycle.
Let’s take a look at what bond markets have priced over the next couple of years. Today, the US terminal policy rate should be reached over Q2 2023 and land between 5.00% to 5.50%. US FED funds 1-year out, March 2024, sit at 4.75%, i.e. 2 to 3 rate cuts. US policy rate estimates for March 2025 settle at 3.48% or another 5 rate cuts of 25bp. Remember that early in 2022, we never thought about rate hiking increments of 50bp, even less 75bp. We got them all over the past 12 months. In that sense, an accommodation cycle can be erratic as well.
The wisdom of markets is telling us that, given an ensemble of risk factors out there (from geopolitics – a global polycrisis condition – over structural indebtedness), an ocean of debt in combination with policy rates too high for purpose, can impact in unpredictable, variable ways.
Just as a reminder: the nominal value of global debt declined by USD 4 trillion in 2022, bringing it fractionally back under the USD 300 trillion threshold breached in 2021, according to a report from the Institute of International Finance (IIF). But the fall was driven entirely by wealthier countries, whose total debt declined by roughly USD 6 trillion to USD 200 trillion. The amount of developing world debt hit a new record high of USD 98 trillion, with Russia, Singapore, India, Mexico, and Vietnam seeing the largest rises. Inflation was helpful.
The ratio of global debt-to-GDP dropped by over 12 percentage points to 338% of GDP, marking the second annual drop in a row. But the improvement was again driven by developed markets, which saw an overall 20 percentage point fall to 390%. The emerging market debt ratio rose by 2 percentage points to 250% of GDP.
The message conveyed by these astonishing indebtedness figures is that the productivity of each unit of USD or EURO or any other currency is falling. Potential growth faces increased downside pressure as the weight of debt starts to increase from 2023 onwards. Indeed, the interest cost of debt went through multi-decade lows across economic agents between 2020 and 2021.
So not only are the monetary lags long, but they are also variable. Indeed, predicting the number of accidents along the policy rate tightening path is difficult. In the past week, we have witnessed a number of US banks faltering. One of the elements that caused their demise was the steep rise in Treasury rates. However, concentration risk, poor asset and liability management practices, and the ability of depositors to wire deposits with a mouse-click were the main culprits for these bank runs. The UK Liability Driven Investment debacle across pension funds in September last year was another canary in the coal mine.
The financial system as we know it today has reached capacity constraints. Central banks are aware. Aside from their traditional inflation and maximum employments mandate they also have the task of preserving financial stability. The decisions taken by the FED, the Treasury Department, and the Federal Deposit Insurance Corporation over the weekend, providing a term facility to the financial system, are wise. These are not bailouts. Equity and bonds of impacted institutions will be wiped out.
Monetary lags will be long and variable. Proper risk management and diversification are the instruments of choice that will protect companies and investors alike.
