The Weekly Tearsheet: COVID stimulus filled a hole that didn't exist
As the inflation data causes investors to pull back rate cut projections this year, it is useful to take a look back and see how far we have come. The Fed hiked the Fed Funds rate by 525 basis points, which is one of the most dramatic tightening regimes in history.
When do you think negative real (i.e. inflation-adjusted interest rates) were last experienced in the economy? The Fed has been hiking for a while, and the current cycle ended 8 months ago. The whole economic concept of zero percent interest rates has been gone for a while, right? Well, not exactly.
The Fed cut interest rates in COVID down to 0% in order to cushion the economy. Inflation re-ignited, and has been running at a 4%-ish range for a long time, while the Fed Funds rate caught up. This means we had an extended period of negative real interest rates.
The idea of negative interest rates is that you penalize savings in the extreme, in hopes of getting consumers to spend money. It in essence “borrows” demand consumption from the future. Since the economy is 70% consumption, this is the quickest way to add demand. It has been typically used in economies in the aftermath of a massive financial crash, where asset prices fall dramatically. COVID may have caused some financial failures, but the typical usage of extreme measures such as negative interest rates is a situation similar to the Great Depression, or the real estate crash of 08. There, the problem is that people have their net worth hit by falling asset prices, and in response they stop spending on anything. Lowering interest rates to 0% helps support asset prices while banks provision and dispose of bad loans.
COVID was not that sort of situation. There may have been a shock to the system, but we didn’t have a stock market crash or real estate crash leading up to it. The government treated COVID like the Great Depression Redux, and it wasn’t. A lot of stimulus was thrown at the economy, and inflation re-ignited.
The COVID pandemic came out of nowhere, in an otherwise fundamentally sound economy. Unemployment was already low. There were no Countrywides, no Fannie Mae’s, no CDO squareds, waiting to get exposed. The financial wreckage of the 2008 were long in the rear-view mirror and credit standards have been tight since then.
The economic patient needed 5 cc’s of stimulus and got 50.
To put the COVID era into perspective, here is a chart of the Fed Funds rate minus the inflation rate. When the number is positive, it means interest rates are higher than inflation, and when the number is negative, inflation is higher than interest rates.
The chart above goes back to 1960. The COVID years were pretty dramatic. Prior to that, we had an extended period of negative rates in the aftermath of 2008, in the aftermath of 9/11 (which coincided with the end of the tech bubble), and in the mid-1970s. The stimulus of 2008 was non-inflationary.
During the 1970s, we had a few instances of negative interest rates mainly as a result of spiking inflation due to oil shocks. Similar to today, there was no burst asset bubble which means people weren’t seeing their net worth decimated. People weren’t licking their wounds because they were healthy to begin with.
This meant that the stimulus went not to paying off debts, but to normal everyday expenses and speculation in real estate. There was no debt hole to fill, which means there was no demand hole to fill. The excess stimulus ended up fueling real estate speculation, leading to a sizeable jump in housing prices. It also found its way into the stock market, leading to a lot of money flowing into a few market darlings like Nvidia.
Now, when do you think real interest rates finally turned positive? About a year ago. So, for most of this tightening cycle, real interest rates have been negative. If the government’s inflation estimates are wrong (i.e. too low), the period of negative real rates might have lasted even longer. If this is the case, it explains the economy’s resilience in the face of tighter monetary policy - because monetary policy might not be tight on a real basis.