NRPLUS MEMBER ARTICLE G dp growth in the first two quarters of last year was negative, inflation was accelerating, and the federal funds rate spent much of the summer in the ones until the end of July. It was easy to look ahead and see the economy dropping into a steep recession in response to the Fed’s tightening cycle. Fast-forward to today’s GDP report that showed healthy growth across the board: This is really the fourth unexpectedly positive reading in a row. What happened? Has the economy stopped responding to monetary policy?
A strong number of course, is not necessarily a sign that monetary policy is not working. Today’s report indicated that real GDP growth in the second quarter was up 2.4 percentage points. Maybe the actual number would have been 4 if monetary policy had not put on the brakes. For that to be true, there would have to be special factors, over and above interest rates, driving the latest numbers. A closer look suggests there are a number of them.
Federal Reserve policy usually works by putting downward pressure on interest-sensitive sectors. These include housing, which tends to be highly responsive to mortgage rates, consumer durable purchases (especially cars), business investment, and inventories. There have been a number of fiscal-policy changes affecting some of these sectors. Let’s look at them in turn.
Consumer spending has clearly been the biggest positive surprise over the last year, on average adding 1.5 percent to GDP growth over that time. Normally, when real wages decline, one expects consumption to follow suit. Yet in this cycle, it has stayed high. Where did the money come from? There are really two different important sources. First, savings during Covid soared, since many people continued to earn their salaries but had little to spend it on while locked in their houses. Add to that a pent-up demand for travel and leisure activities, and consumers have been able to finance very rapid consumption growth for the types of nondurable goods that are usually not very interest-rate sensitive.
But, secondly, even the most interest-rate sensitive consumer product, the automobile, has not exhibited the normal negative response to higher rates. Last spring, light-vehicle sales were well below trend, at 12.5 million units per month. Today they are closing in on 16 million, despite the steep rise in interest rates. This could, as with travel, be a pent-up-demand story, but there is another factor. The so-called Inflation Reduction Act provided a $7,500 credit for the purchase of an electric vehicle, more than offsetting any negative effect of higher interest rates. With electric-car supply constraints easing, sales have headed north at a sharp rate, rising 50 percent relative to last year.
Business spending, on average, has contributed 0.6 percent to GDP growth over the past four quarters, hardly the sharp decline that one typically sees in a Federal Reserve tightening cycle. Its surprising strength could well be related to two special factors. First, the administration has pursued a number of “onshoring” initiatives. For example, the electric-vehicle credit is only available for electric vehicles produced in the U.S. Second, the 100 percent expensing that was was approved in 2017 has begun to phase out by 20 percent per year. This year, 80 percent of an investment can be expensed; next year it drops to 60 percent. This gives firms a strong incentive (especially given the high inflation rate) to buy capital goods this year before their tax benefit shrinks.
The other two interest-sensitive sectors are responding well, as far as the Fed’s model is concerned. Pummeled by high mortgage rates, housing has subtracted 0.74 percent from GDP on average over the past four quarters, more than offsetting the positive push from business spending. This decline is consistent with previous tightening cycles. Inventories, too, have shown their normal responsiveness. Recall that the cost of carrying inventory is the interest rate, so profits are deeply affected when rates rise. Over the past four quarters, inventories, while volatile, have subtracted on average about half a percentage from quarterly GDP growth.
Thus, the big story is that the interest-sensitive sectors have not really responded the way they have in the past to Federal Reserve tightening. As for the top-line number, there is one other factor that has worked against the Fed’s attempt to bring growth down: surging government spending. Over the past four quarters, government spending has added almost 0.7 percent to growth each quarter. Congress is pushing, while the Fed is pulling.
Looking forward, the Fed will have to raise rates until growth gets well below 2 percent. The excess Covid savings are about exhausted, so downside pressure on consumption can be expected. But the onshoring of business investment and the front-loading to take advantage of the expiring expensing rules will likely continue to be major factors in the second half of the year, as will the steady contribution of government spending. We are in a very strange time, when major recession indicators such as the yield curve and the index of leading indicators are blaring recession, but special circumstances are keeping variables elevated compared with where they would normally be in a tightening cycle. Don’t be surprised when the federal funds rate hits 6 percent.