Monetary Policy Difficult Path Forward

Chief Economist Eugenio J. Alemán discusses current economic conditions.

We have read plenty of analysis on what the Federal Reserve (Fed) should do as it decides when to start lowering interest rates this year. Much of the analysis is well-intentioned as well as based on very good arguments. However, some of these arguments seem to be based on a presumption of perfect foresight. That is, the analysts who make these arguments seem to feel that they know, with certainty, what is going to happen in the future.

We are a bit humbler when we make our arguments. Although we have a forecast of what we think is going to happen, we never know when and if the economy could throw us a curve ball. And we think the Fed should also remain humble regarding what it believes the future to look like. Many arguments we have heard say that interest rates are too high and keeping them high for too long risks sending the U.S. economy into a recession – even though inflation has come down considerably while the rate of unemployment has stayed below 4.0%.

One of the counterarguments to this issue is that so far, these high interest rates have not done much to slow down economic activity in any measurable way. And once again, we continue to argue that what happened during the last several years was not a typical monetary cycle but fundamentally a fiscal cycle. Monetary policy has not been as effective in slowing down the growth rate of the economy as it would have been had the cycle been created by the expansion of credit, i.e., through the money multiplier.

But even if these higher interest rates have not been able to derail the U.S. economy so far, the effects of higher interest rates have not been innocuous even in this environment, as the U.S. economy experienced several negative shocks from higher interest rates: First, real gross private domestic residential investment declined for nine consecutive quarters on an annualized, quarter- over-quarter basis, starting in the second quarter of 2021 and up to the second quarter of 2023, after which it recovered slightly during the third quarter of last year. However, these declines in real residential investment were not able to derail the overall economy.

Residential Investment Contribution to GDP