Wednesday's Market Minute: "Lagged Effects" Is The New "Transitory"

Jerome Powell gets to take another stab at it today. Last week’s message was messy from the start, when the Fed Chair called the decision not to hike rates a “skip,” before catching himself, saying “I shouldn’t call it a skip.” It’s indeed hard to know what to call it when you’re trying to have it both ways.

In justifying the Fed’s decision to not hike rates last week, Powell embraced a popular concept among financial media and economists lately: that we should wait to assess the “lagged effects” of the extensive rate-hiking regime of the past year.

It’s a phrase you hear a lot right now. It refers to the delayed, unknown effects of monetary policy tightening that aren’t obvious during the actual process of raising interest rates. There are a few risks in being overly reliant on this concept, especially if -- as the FOMC's Dot Plot told us last week -- inflation is an even bigger problem than expected. 

First, conceptually, we should expect the “lag” between policy and the economy to always be shortening with time. The better we understand how the economy works, combined with the speed at which the exchange of information, goods and services is effectively always increasing, “lagged” effects should lag a little less each cycle. This is particularly true today in the social media era that just saw the widest stock-market participation in history. More people than ever are tuned into what the Fed is doing and basing investment, capital allocation, and discretionary consumption based on the interest-rate level.

Second, there is evidence of significant effects already. The stock market crashed last year and did so almost perfectly inverse to interest rates. Unprofitable startups went belly-up, the IPO and SPAC boom stopped on a dime, and weak companies went bankrupt. Even the incredible housing boom of the Covid era hit a wall. By the old standards of back-to-back quarters of declining GDP, we did get a recession last year! Most recently, regional banks tied to the tech fallout went bust. 

It seems that bank scare is what’s keeping Powell from fighting inflation the way he said he would last year. But if he’s truly data-dependent, it’s hard to justify a lot of fear about the economy. Credit spreads look completely innocuous, financial conditions are the loosest in a year, and economic data’s beating expectations at near the best rate since 2021. He even admitted in the press conference that housing is heating back up again. 

Not only are “lagged effects” likely an overstated concept in today’s connected world, there’s compelling economic evidence to think they’ve already come and gone. By giving the economy relief today, the Fed risks repeating the mistake of “transitory,” and allowing inflation to re-root, setting up another aggressive hiking campaign down the road.

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