Most importantly, monetary policy turned restrictive earlier this year, and is likely to remain so for an extended period of time. Even if further disinflation opens the door to rate cuts next year, these cuts will be gradual until policy makers regain full confidence that inflation is on a sustainable trend towards two percent. As a result, interest rates will likely remain high for the foreseeable future, and will increasingly weigh on household and business spending.


Figure 1: Measuring the Monetary Policy Stance: Real Policy Rate less Neutral Rate

Source: Federal Reserve Banks of Philadelphia and New York, University of Michigan, Bloomberg, MacKay Shields . Real policy rate calculated by subtracting one-year inflation expectations from the effective federal funds rate. One-year inflation expectations based on the average of the inflation swap rate, and median expectations from the Survey of Professional Forecasters and the University of Michigan Survey of Consumers. Neutral rate estimate is from the Federal Reserve Bank of New York's Holston-Laubach-Williams model. Shading indicates NBER recessions.

In addition, sources of resilience that supported growth this year should continue to fade. Households and nonfinancial corporates have run through a substantial portion of the stock of liquid assets built up in recent years. In addition, while the vast majority of homeowners locked in low mortgage rates prior to Fed tightening, the rise in rates on credit card debt, auto loans and other consumer loans has had a more noticeable effect on consumer finances, taking total household interest payments as a percent of income up to levels last seen during the Great Recession of fifteen years ago. Not surprisingly, the burden of higher borrowing costs is an increasing source of stress for many households; data from the Federal Reserve Bank of New York indicate that delinquency rates on auto loans and credit card debt continue to increase and are now above pre-COVID levels. And borrowing conditions for households are only becoming more challenging; on net, banks report continued tightening of lending standards across all categories of consumer loans.


Figure 2: Household Interest Payments as a Percent of Disposable Income 

Source: Bureau of Economic Analysis. Shading indicates NBER recessions

Pressure on household balance sheets will likely increase further, as wage growth has continued to moderate amidst a cooling in labor demand. While economy-wide layoffs remain quite low, firms appear to be cutting back on labor on the margins, as seen in the decline in total overtime hours worked and temporary employment payrolls. And stripping away education and health care employment, which tends to have little correlation with the economic cycle, service sector jobs growth has fallen to anemic levels.


Figure 3: Service Sector Jobs Growth excluding Health Care and Education

Source: Bureau of Labor Statistics, MacKay Shields. Six-month moving average. Shading indicates NBER recessions

With signs of labor market softening and inflation moderating, it appears that the monetary tightening cycle has come to an end. But the central bank’s task now becomes more challenging, as risks to the outlook are now two-sided. Cutting rates too quickly to support growth and employment risks inflation stabilizing at too high a level, or potentially picking back up. Alternatively, keeping policy restrictive for an extended period risks a recession and a significant rise in unemployment. To navigate the year ahead successfully will require significant agility, from the Fed and investors alike.


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