How much do 'long and variable lags' matter?
The evidence so far suggests not a lot.
The current debate isn’t over the concept of “long and variable lags” in the effects of monetary policy on the economy—observations from past cycles tell us this tends to be true. But with the Fed 17 months into its latest rate-hike cycle, and with another quarter-point increase possible before year-end, a fair question may be, how much will these “lags” matter? It is not much of a logical stretch to point out that the post-pandemic liquidity surge—some $9+ trillion pumped into the economy in just over a year—and an extended period of historically low rates that actually dates back to the global financial crisis (GFC) have left the pool of domestic households and corporations alike far less rate sensitive than in prior cycles. And by the time all the lags potentially hit, it may not make much of a difference.
Consider, in 10 of the 13 calendar years starting with the exit from the GFC in 2009 and ending March 2022 when the Fed initiated its current rate-hike cycle, the federal funds target rate effectively was anchored at zero. Acting rationally, borrowers during this period took advantage by extending the maturities of their debt and locking in low rates. Approximately 60% of consumer debt consists of long-term fixed-rate mortgages—just 31% of outstanding mortgages had a rate above 4% as of last September, according to the Federal Reserve Bank of Dallas. Household debt service payments relative to income, though rising, remain slightly below pre-Covid levels, which were themselves at multi-decade lows. Along with ongoing employment strength, this lack of pain so far from escalating interest rates is enabling consumer spending to routinely beat expectations.
The story is similar for corporations. Over the past few weeks, it was striking in Q2 earnings calls how consistently CFOs made a point to note how near-term maturities have been extended and exposure to rising rates has been mitigated for the foreseeable future. Again, rational actors acting in their self-interest given the environment they find themselves in. The experience of non-financial corporations in some ways has been the mirror image of that of banks, which funded with short-term liabilities (deposits) and invested in longer-duration assets (loans and securities), faced material pressure as rates rose and the yield curve inverted. In contrast, with their liability maturities extended, corporations lessened their exposure to rising rates while also benefitting from better returns on cash holdings. The evidence is in the aggregate S&P 500 ex-financials net interest expense tally, which has declined over the period the Fed has been hiking rates as the improvement in their short-term investment income (think yield on money-market instruments) has more than offset the increase in their interest costs.
All this suggests regardless of whether the Fed is done, big chunks of the economy—remember, the consumer effectively represents 70% of GDP—are suffering smaller-than-usual hits from rising interest costs, dragging out the gestation period for the Fed’s rate headwinds. A glass half-empty perspective may conclude the worst is still ahead of us from the rapid run-up in rates. Possibly, even though two big rate-sensitive sectors, housing and autos, are showing signs of perking up. A glass half-full view—one that we increasingly are willing to embrace—is that the day of reckoning is more likely several years away. The pain only manifests itself when the debt is due. And by the time that comes, the headwinds may prove milder than many anticipate, given projections that show the Fed beginning to cut rates next year. This so-called “golden path” of declining inflation and still solid employment and economic growth, as one Fed governor recently described it, would be supportive of earnings and equity markets. In other words, time may be on the side of the economy, regardless of the lags.