The Federal Reserve at its next meeting on Oct. 28-29 will once again be faced with setting monetary policy amid a weakening labor market and persistent inflation.
When the central bank wants to bolster accommodation, it relies upon the financial channel to affect economic activity.
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Yet with the housing market in a slump and lower-income households feeling the sting of higher inflation, this transmission mechanism—whether it shows up in consumers having more cash to spend or businesses taking on more risk—may not be as effective as in the past.
The result is a longer lag between rate cuts and when those cuts are felt in the real economy. It’s happening in different ways:
- Housing market: Consider mortgages. With many households holding mortgages well below the current rate on a 30-year mortgage of 6.38%, the usual wave of refinancing that has accompanied rate cuts in the past is simply not going to happen. Consumers, as a result, will not see a rise in their disposable income.
- The labor market: Constraints on the labor supply are clogging up what in the past has been a valuable channel to bolster growth through lower rates and risk taking by the corporate community. The slow hire, slow fire labor market then results in a less efficacious monetary transmission mechanism.
- Corporate finance: With corporate balance sheets in the best condition they have been in decades featuring substantial reductions in short-term debt, the lag time in how rate cuts affect the economy is likely longer than it has been in the recent past.
As we illustrate, monetary policy is transmitted to the economy through changes in the policy rate. An increase or decrease in the policy rate directly affects financial conditions and the degree of risk priced into the cost of credit.
A reduction in the Fed’s policy rate decreases the day-to-day cost of doing business, which reduces prices and stimulates consumer spending.
That spending dictates the level of economic activity and the level of inflation as the demand for goods increases or decreases.
While we are certain that lower rates, increasing liquidity and rising leverage bolster financial activity among businesses and higher-income households, these benefits are taking longer to reach lower-income households than in the past.
