The worry, arising from some important new research, is that the benefits of Fed rate cuts in today’s environment may be substantially overrated.
Typically, when rates drop, consumers buy more durable goods like washing machines and cars, homeowners refinance their mortgages and effectively get a tax cut, and businesses invest more because the cost of borrowing goes down. But lower rates may have much less impact on these behaviors now. In the language of economics, the economy is suffering from a “weakened monetary transmission mechanism.”
Take spending on consumer durables. A recent study by economists at the Federal Reserve Bank of Minneapolis and the University of California, San Diego, notes that these purchases occur in lumpy spurts. People tend to spend nothing on such items for long periods, then spend a lot all at once, when money is cheap and prices are enticing.
The problem now is that once-in-a-lifetime offers don’t generate the same excitement if they are repeated every week. And, the study suggests, after 10 years of extremely low interest rates, there probably aren’t many consumers with pent-up demand, waiting for rates to fall. Because so many people have already made their big purchases, the economic kick from a rate cut is smaller than it would be at a “normal” time.
Economists at Northwestern, Copenhagen University and the University of Chicago’s Booth School of Business have shown the same thing about mortgages. Because most mortgages have fixed rates, a Fed rate cut will affect these homeowners only if they refinance.
Typically there’s a large group of people with a pent-up demand for a cheaper mortgage, and once they get one, the benefit is roughly equivalent to receiving a big tax cut: They have a lot more money to spend on other things. But if rates have already been low for a long time, most of those people will have already refinanced along the way. A cut in rates will not deliver the same punch it usually would.
A similar dynamic probably helps explain why the 2017 corporate tax cut has had such an underwhelming impact on companies’ capital investment. Fundamentally, there wasn’t much pent-up demand for investment after years of low rates, accelerated depreciation, “temporary” investment expensing and other stimulus. That lack of pent-up demand also means that cutting interest rates now is unlikely to entice businesses to invest much more.