Tight monetary policy and consumption patterns

Throughout economic cycles (both recession and boom periods), the Federal Reserve raises and lowers interest rates to achieve its mandate of stable prices and maximum sustainable employment. When the Federal Reserve raises interest rates, it is said to be “tightening” monetary policy. A higher interest rate can help check high inflation because, the theory suggests, access to credit becomes more expensive (ie, financial conditions tighten), which reduces consumption and investment. In turn, companies adjust prices and inflation falls.

In this article, we analyze the connection between the effective policy rate and the consumption of goods and services during the last five episodes of monetary policy tightening, emphasizing the most recent experience.

Measurement of the monetary policy rate at the zero lower bound

The federal funds rate is the target interest rate set by the Federal Open Market Committee for overnight interbank lending. Although the Fed conducts monetary policy primarily through the federal funds rate, it must use other tools if it wants additional stimulus when the federal funds rate approaches zero. This is because central banks find it difficult to push short-term interest rates below zero, as people may decide to hold cash rather than lend money at negative interest rates. Therefore, when short-term rates hit zero, the Fed employs other tools, such as bond purchases, that push down medium- and long-term rates to stimulate economic activity, a method known as quantitative easing. .

Comparing the monetary stimulus from policies such as QE with that from ordinary levels of short-term interest rates is difficult because short-term rates do not reflect the stimulus of QE. To facilitate that comparison, economists Jing Cynthia Wu and Fan Dora Xia estimated a “shadow rate” that describes the hypothetical short-term rate that would provide the same stimulus as the quantitative easing being applied.

We define the effective policy rate (the black dotted line in the figure below) as the effective federal funds rate (the blue line) above the zero lower bound. The effective policy rate is defined as the shadow rate (the yellow line) when the effective federal funds rate is at the zero lower bound. Gray bars indicate episodes of monetary policy tightening. The graph shows that the effective monetary policy rate increases throughout these adjustment episodes.

Behavior of personal consumption throughout the episodes of tightening of the monetary policy

The following figure shows how a measure of personal consumption expenditures (PCE) moves during the same adjustment episodes (again indicated by the gray bars). The PCE measure (the blue line) is both in real terms (meaning it is adjusted for inflation) and detrended (meaning it is calculated as a percentage deviation from its trend). We refer to this measure of consumption as the actual consumption cycle. Negative values ​​indicate lower than normal household consumption, while positive values ​​indicate higher than normal consumption. For simplicity, we exclude the effective policy rate reported in the above figure, as the gray bars provide information about when the effective policy rate is increasing.

The previous figure yields several observations. In the 1994 adjustment episode, when the effective policy rate began to rise (as indicated by the start of the gray bar), the real consumption cycle was at its peak. Then, as the effective policy rate increased, real consumption declined and eventually turned negative, indicating below-normal consumption. This is exactly the pattern predicted by the theory we described at the beginning of our article. The pattern is similar, but delayed, in the subsequent hardening episode (1999); consumption began to decline 16 months after the adjustment episode began.

By contrast, consumption increased in the 2004 contraction episode and remained relatively close to its trend in the 2014 contraction episode. Thus, the way the theory suggests that consumption should behave during periods of Tight monetary policy is not clearly observed in at least two of the first four tightening episodes in our analysis. Lockdowns and uncertainty associated with the COVID-19 pandemic brought consumption down rapidly in 2020. However, it returned to trend relatively quickly, before the most recent tightening episode began in late 2021.

Consumption and financial conditions during the 2021 adjustment episode

The following figure focuses on the most recent tightening episode, the beginning of which is marked by the vertical dashed line. For simplicity, we include only the effective policy rate as previously defined (the black line below) and exclude its effective federal funds rate and shadow rate components.

As the figure illustrates, consumption as measured by the actual consumption cycle (the blue line) decreased slightly after the start of the 2021 adjustment episode. Despite small fluctuations like that, the actual consumption cycle has consistently hovered around 2% above trend since the beginning of the adjustment episode. Positive values ​​of the actual consumption cycle indicate that consumption was higher than normal. Slower growth in the last two months of 2022 supports the theory that monetary policy tightening reduces consumption, but this evidence is weakened by the fact that consumption remained above normal.

The green line represents a financial conditions index constructed by Goldman Sachs. A higher value on the index indicates that it is more difficult to borrow and invest, for example, due to higher borrowing costs for companies or lower share prices. In general, the index tracked the movements of the effective monetary policy rate before and during the 2021 tightening episode; however, in the last two months of 2022, the index declined, meaning that financial conditions eased despite the Fed’s interest rate hikes. Since the start of the tightening episode, most months they have posted average or better-than-average financial conditions (an index value below 100), which may help explain why consumption has remained high over this period.

In conclusion, there is some evidence, albeit weak and not recent, that the real consumption cycle declines during episodes of monetary policy tightening. In 2022, consumption remained about 2% above trend. In addition, financial conditions, shown by the Financial Conditions Index, improved by the end of 2022 despite the Fed’s tightening monetary policy. Looking ahead, it may be important to track the correlation of the Financial Conditions Index and the rate. of effective monetary policy, which have recently diverged, to predict the behavior of consumption and inflation.

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1. This logic is close to the description of the Phillips curve in this European Central Bank May 2020 Working Paper (PDF).
2. Short-term rates are those with a maturity of less than one year. The federal funds rate is a short-term rate.
3. See your paper, “Measuring the macroeconomic impact of monetary policy at the zero lower bound”, published in the March 2016 issue of the Money, Credit and Banking Magazine.
4. We focus on five episodes of hardening. Their start dates are February 1994, June 1999, June 2004, May 2014, and November 2021.
5. This measure of percentage deviation from the consumption trend is given by applying the Christiano-Fitzgerald bandpass filter with a minimum period of three months and a maximum period of 96 months to the actual recorded consumption expenditures. The purpose of a bandpass filter is to obtain the cycle by removing very short fluctuations (less than three months in this case) and the trend (more than 96 months in this case) from a time series. Check out the NBER working paper by Lawrence Christiano and Terry Fitzgerald “The Band Pass Filter” (PDF) for a more detailed explanation.