This Macro Plot Twist Helps Explain Everything

Once again, the market has vastly underestimated the strength of the American economy. First it was the resilience of the job market, then the unrelenting persistence of the consumer, a substantial recovery in manufacturing, and now, inflation. This was always the potential catch of a Trampoline Landing : that inflation would bounce alongside growth once the Covid-warped supply-chain kinks got worked out. Economists who’ve been insisting that “lagged effects” from rate-hikes would send the economy into a tailspin are left grasping at straws.

The textbooks tell us the 2022-23 hiking cycle – one of the most intense ever by the Federal Reserve – should be applying fairly extreme pressure onto the economy. Instead we’re averaging 4% GDP at 3.7% unemployment, printing 300,000+ payrolls reports.

All those rate hikes must break the economy eventually, right? Plot twist: maybe it’s closer to the opposite. Perhaps hiking interest rates off the zero bound is actually, initially, a stimulative thing.

It sounds opposite to the common logic that higher rates tighten financial conditions, but we already have a decade of evidence from Japan that zero rates don’t spur growth. What if too-low rates actually hinder it?

It's a theory that’s been teased around by financial commentators before, but resonated with me after a conversation yesterday with Zed Francis of Chicago-based Convexitas. He’s one of the most underappreciated macro analysts in the game, and his point centers on the corporate tradeoff between shareholder-friendly activity and investment. When rates are near zero, corporations are happy to avoid the risk of capital expenditures in favor of buying back stock or issuing dividends. When rates rise, the math behind buybacks gets less appealing and gets replaced by new projects and investments. Guess what – a study by Bank of America last summer showed S&P 500 cap-ex just rose for nine straight quarters, a stark shift from the previous decade.

People keep arguing the Fed needs to cut because rates must be restrictive at this level. Firstly, there’s no evidence of it in financial markets or the economy. More importantly, the premise may be wrong. There’s a lot of debate around where the neutral interest rate is, the level at which policy is innocuous to the economy, but most people think about it as an upper bound: go beyond it, and things worsen. More likely is that it’s a range, with a lower bound that must be surpassed in order to jumpstart activity.

Think about it as potential energy getting released. When rates are too low, money gets sluggish as established companies aren’t incentivized to take risk. When the Fed hikes, the potential energy becomes kinetic. One place we saw this fairly explicitly was in housing: as soon as people realized the Fed was going to go on a hiking spree, mortgage apps soared and the housing market took off. It still probably stands to reason that eventually, sustained higher rates will apply pressure, but that will depend on how much potential energy we had in the tank. Right now it’s looking like we had a lot.

A.I. breakthroughs are helping fan the flame of corporate spending most recently, but the notion that rate hikes are not an absolutely negative force would go a long way in answering why analysts continue to be too bearish on the economy, why resilience has turned to renewal, and why the Fed is right to be patient before cutting.

**Update: I guess I should have realized that David Einhorn argued something similar last week in an interview with Bloomberg. Here's that link (relevant section near end).