Why is the Fed's interest rate hike not high enough?

The current limited scope of Fed rate hikes indicates that despite maintaining a rate range of 5.25%-5.5% for nearly a year, the US economy has been slow to "land", reflecting that monetary policy may not be significantly restrictive. Even in the case of weaker-than-expected CPI in May, Fed officials like Bowman still maintain an open attitude towards rate hikes; this means that from a perspective of combating inflation, US interest rates are still not high enough.

The Fed has pointed to higher long-term rate expectations in the SEP forecasts for two consecutive times this year; and the theme of this year's Jackson Hole central bank annual meeting was set early on as "reassessing the effectiveness and transmission of monetary policy". Prior to last year's global central bank meeting, the Fed hinted at a "natural rise in post-pandemic neutral rates", and this year's agenda can be seen as a continuation of last year's discussions, reflecting the Fed's year of reflection and summary.

The endpoint of capital market rates is also evolving in the direction of "monetary policy not being sufficiently restrictive", as seen in the continuous rise of long-term rates post-pandemic. Since the third quarter of last year, long-term rate expectations have been maintained above 3.5%, rising more than 1.2 percentage points compared to the average from 2017 to 2019.

The limited extent of US monetary policy restrictions is due to "not raising rates enough and not tightening fast enough", rather than poor transmission.

In a previous report titled "The Fed Should Not Cut Rates Unless Necessary", we believe that the US nominal neutral interest rate may have risen to around 3.8%. The corresponding 5-year Treasury yield is currently only at the level of 4.3%, even dropping close to 3.8% at the beginning of the year; from this perspective, monetary policy indeed lacks clear restrictiveness.

Not tightening fast enough is reflected in the fact that US bank reserves are still abundant, remaining close to the level at the start of rate hikes in April 2022. Interbank liquidity has not been significantly affected by a large-scale contraction of balance sheets, thereby maintaining the basic stability of financial market financing functions, which naturally makes it difficult to curb investment and consumption activities.

On one hand, a higher government investment inclination and resident consumption tendency have led to a relative shortage of capital elements; from 2022 to 2024, the proportion of US resident consumption to disposable income has increased by 2 percentage points to 92.7% compared to the average of the decade before the pandemic.

On the other hand, large-scale immigration has boosted the short-term trend labor input level in the US. With capital input intensity remaining stable, potential growth rates have also increased.

Both factors have contributed to the rise of the natural interest rate, bringing upward pressure to equilibrium rates. The rise of the natural interest rate implies a decrease in the restrictiveness of monetary policy.

During the epidemic, a large amount of low-interest refinancing by corporate sectors has lowered the level of interest expenses, which has not rebounded until 2024Q1; and despite historically high post-tax profits, the corporate sector's debt repayment ability remains healthy. The current ample financial liquidity has kept credit spreads at low levels; the total issuance of non-investment-grade corporate bonds in the United States in the first 6 months of 2024 has already exceeded the full-year level of 2023.

Against the backdrop of the opening of a big fiscal era, the boundaries of monetary policy are becoming clearer. Currently, the U.S. economy has not shown signs of significant slowdown, with only a few interest rate-sensitive sectors loosening, and fiscal policy can still be targeted. Whether before or after the election, engaging in preemptive rate cuts to support the economy is a thankless task for the Fed.

The Fed did not excessively raise interest rates, but stopped at the point where nominal rates and natural rates were just matched, reflecting the Fed's attitude - not to compete with fiscal policy. Even if inflation is difficult to return to 2%, actively creating a recession is not an option, so the Fed emphasizes observing data repeatedly. Even if it inevitably falls into a situation of acting too late in the future, it must support the flag of fiscal expansion, because fiscal policy is the core of the U.S. economy today.

Therefore, between the perspective of "insufficient rate hikes" from a control inflation standpoint and "moderate rate hikes" from a fiscal perspective, the Fed actively chooses to lean towards the latter. The cost is the stagnation of the de-inflation process within the year and the intensification of economic activity fluctuations, and what the Fed can do is to minimize fluctuations, that is, to maintain interest rates stable before the economy significantly weakens.

Author: Tianfeng Macro Song Xuetao (Practice Certificate Number: S1110517090003), Source: Xuetao Macro Notes, Original Title: "Fed Didn't Hike Enough? (Tianfeng Macro Song Xuetao)"