The limits of what high interest rates can now achieve

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The first quarter’s run of higher than anticipated US inflation numbers have markets in a tizzy. Investors have been constantly tweaking their expectations for interest rates. The problem with all the frantic repricing is that it bestows an incisiveness on monetary policy that it does not actually possess — particularly at this stage of America’s inflation battle.

Rate-setting has become the focal tool to guide economies. Fiscal policy is politicised and limited by budget constraints, and supply-side reforms take longer than the electoral cycle to bear fruit — although both are arguably sharper instruments. Tax and spend decisions can be targeted, and their impact on demand is faster. Land, labour and capital reforms can boost long-run supply.

Nonetheless, the US Federal Reserve has historically played an important role in keeping inflation tame. Higher rates have helped pull price growth down from recent highs. But we need to be realistic about what rates can now achieve.

First, the so-called transmission mechanism — or how rates affect demand — may be weaker in this cycle. Data from a Federal Housing Finance Agency staff working paper shows that between 1998 and the pandemic, the share of Americans on mortgages with rates locked in more than 1 percentage point below the market rate was never far above 40 per cent. Yet, at the end of 2023, about 70 per cent of mortgage holders had rates more than 3 percentage points below what the market would offer them on a new loan. Higher for longer rates may be futile.

The impact of monetary policy can also be damped as economies become more service-intense. The manufacturing and construction sectors are more capital-intensive and more readily affected by rate changes.

The implication of lower economy-wide rate sensitivity is that policymakers need to either wait longer for existing rate rises to take effect, or go higher. But some sectors are hit by higher rates faster, and harder, than others. Research by the San Francisco Fed shows spending basket components including transport and financial services are the most responsive to higher rates.

Today, America’s sticky CPI holdouts are shelter and motor vehicle insurance. Both are partly a product of pandemic supply shocks — reduced construction and a shortage of vehicle parts — that are still percolating through the supply chain. Indeed, dearer car insurance now is a product of past cost pressures in vehicles. Demand is not the central problem; there is little high rates can do.

This raises further problems. If rates need to stay higher to account for these less rate-sensitive components, that raises the risk of surplus stress being placed on more responsive areas. They can be over-squeezed, break and spill over more uncontrollably through the economy. It also means some parts of the population take on a higher burden. “Hand-to-mouth” households — which have large spending commitments compared to their regular income and liquid assets — can be particularly exposed to rate risk.

Breaking one part of the economy to slow the rest down is a feature of monetary policy, not a bug. Historically, the Fed’s rate-rising cycles have tended to culminate in a recession or financial crisis. Some economists suggest a more optimal monetary policy might instead monitor a price index with greater weights assigned to larger, stickier and more upstream industries, to limit the inefficiencies caused by interest rates across different sectors.

Either way, monetary policy is a catchall tool. It cannot control demand in a quick, linear or targeted manner. Other measures need to pick up the slack. Estimates suggest supply factors — which rates have little influence over — are now contributing more to US core inflation than demand. Tighter fiscal policy can squeeze demand further. Housebuilding can alleviate sticky shelter price inflation. Or, we can lean on higher rates until less rate-sensitive sectors are hit, or until the more sensitive ones crumble and drive a broader downturn.

We need to wake up to the limits of monetary policy, in the US and elsewhere. That means fiscal policy, financial stability and supply-side measures need more prominence in the price stability debate. Better policy co-ordination may be necessary. But there are also questions for central banking. For instance, how rigid should any inflation target be when the spread, and nature, of price pressures also matter?

If too much rests on the power of interest rates, ongoing volatility will be the result. Monetary policy can certainly help soften fluctuations in the economy. But other tools are needed to overcome the limitations of rate setting itself.