An idea seems to have gained ground, even among some very serious observers, that the most rapid hiking cycle since Volcker has nothing to do with the present disinflation. “Many commentators rushed to give credit to the Federal Reserve,” Paul Krugman writes, “But the more I look at that claim, the less plausible it seems.” “These happy circumstances have led some observers to congratulate Powell and the Fed on achieving a “soft landing,” opines James K. Galbraith, “But crediting the Fed is magical thinking.”
No one seriously disputes that exogenous shocks related to the pandemic and the Ukraine war played a significant role—first inflationary and then disinflationary. The Fed can’t do much about that. What it can do is temper demand. This is especially important if inflation is at least partly being driven by shocks to aggregate demand. Is it?
The issue is not beyond empirical decision. We know that demand shocks result in prices and quantities moving together while supply shocks result in prices and quantities moving in opposite directions from each other. The SF Fed reports the results of this computation, which clearly shows that demand-side factors have played an increasingly important role alongside these supply-side shocks in the present cycle.
Krugman is skeptical of that Fed policy is responsible for much of the disinflation because of (1) the aforementioned supply-side shocks on which there is no disagreement; and (2) that monetary policy, in his framework, is supposed to arrest aggregate demand growth by pushing unemployment above the natural rate, and that hasn’t happened.
It is true that, at 3.5 percent, the unemployment rate remains exceptionally low. This certainly rules out the labor market channel of monetary policy transmission. Indeed, it is dispositive proof against the Phillips curve theory. We’ve long argued that the Phillips curve paradigm of inflation needs to be abandoned. Perhaps now mainstream macroeconomists will revisit their basic understanding of the inflation process. Regardless of the state of macro’s intellectual development, that we have disinflation despite an exceedingly tight labor market does not constitute any proof against the Fed’s work—they merely rule out Krugman’s and others’ theory of how inflation works!
Monetary policy transmission has been studied more seriously by other scholars. (Krugman is the pioneer of the new trade theory; this is not exactly his field—but who am I to gatekeep?)
One channel is the bank capital channel whereby higher rates reduce bank capital because of a balance-sheet maturity mismatch and thus constrains banks’ capacity to lend (Bolton and Freixas 2000, Van den Heuvel 2002, Brunnermeier and Sannikov 2016). Bank capital peaked in 2021Q4 at 12.34% of disposable income. It has since fallen to 11.38% of disposable income.
Another channel is the bank reserve channel whereby higher interest rates raise the opportunity cost of holding reserves, leading to lower deposit creation (Bernanke and Blinder 1988, Kashyap and Stein 1995). Yet another channel works through the market power of the big banks during hiking cycles leading again to lower deposit creation (Drechsler, Savov, and Schnabl 2017).
We can easily verify that tighter policy as indeed been working through these three channels to reduce deposit creation. US bank deposits have fallen from 2022Q1 peak of 99.0% of personal disposable income to just 87.0% by 2023Q2.
Finally, there’s a risk appetite channel whereby tighter monetary policy in the center country reduces risk appetite of global financial intermediaries and thereby arrests credit growth in the global financial system (Rey 2015). The market capitalization of US blue-chip stocks, suitably detrended, contains a good signal of risk appetite because it captures the valuation level of the premier risk asset in the global financial system. The market cap of the five hundred largest US companies peaked at just over 200% of disposable income in 2022Q1, falling to 160% by 2022Q4, where it has stayed put.
So these channels are indeed working as advertised. Galbraith mentions an interesting confounder—that higher receipts from larger interest payments may increase aggregate demand through a wealth effect. He calls this the “fiscal channel”, although it would be more correct to call it a confounder of monetary policy transmission.
The “fiscal channel” for interest-rate payments is an inconvenient concept for those who wring their hands over the “burden” of public debt. It suggests that Powell’s rate hikes may be powerless to slow GDP. Indeed, additional rate increases could even be expansionary, at least up to a point.
James K. Galbraith. Project Syndicate, August 2023.
Interest income of US households has clearly increased at the margin because of the more attractive interest rates on offer. But how much can this move the needle on demand management?
The answer is not very much at all. Interest payments have increased by just 0.25 percent of disposable income. Whatever wealth effect that may have has been totally swamped by the -40 percent wealth shock from the stock market.
All these channels ultimately work through tempering the pace of credit and deposit creation. We can see that the Fed’s hiking cycle, working through these channels and perhaps others, has reduced deposits from 99% of disposable income in 2022Q1 to 87% in 2023Q2. Total bank credit outstanding peaked at 92% in 2022Q3; already by 2023Q2, it had fallen to 88% of disposable income.
All monetary policy channels ultimately assume that lower bank credit and deposit growth temper inflation. Although there’s no dispositive evidence so far, what we can see is consistent with this paradigmatic assumption of the literature. Demand-driven inflation surged as bank credit grew beyond 90% of disposable income. As bank credit growth has tempered, so has inflation.
We find the same story with total deposits at US banks, which should have an even stronger demand destruction signal. Note that these two graphs look very similar if we replace demand-driven inflation by core PCE, so they are robust to different specifications.
The evidence from the historically unusual post-Covid cycle so far is consistent with the modern understanding of monetary policy transmission. To be sure, all these channels take their time to work through the system—measured in many quarters. So, a lot of tightening is already baked in. Even if the Fed does not hike anymore—although that is not a wager you should be making at this time since there’s evidence to suggest that trend inflation in settling in at 4% per annum—the hikes already on the books will be working to destroy demand deep into 2024. Given this monetary reality, it remains to be seen whether the Fed can still achieve a soft landing.
We’ve shown that monetary policy transmission has been working exactly as expected. Even if the labor market remains tight, demand has been destroyed through tight money, which has tempered inflation. So, contra Krugman and Galbraith, the Fed indeed does deserve credit for the disinflation.