The Fed Is Working on the Vibes

Are interest rate cuts what's needed to bring consumer sentiment in line with economic performance?

Dear readers,

If you haven’t been following the “vibes” debate, there’s been a lively conversation among economic commentators over the last couple of years about whether the American public is unreasonably dejected about economic conditions — experiencing “bad vibes” to an extent that cannot be justified by the data — and, if so, why.

I haven’t weighed in very much because I haven’t felt like there’s much to say. Measures like the inflation rate and the unemployment rate are objective, but voters’ decisions about which aspects of the economy really matter are subjective, as are their assessments about what kind of economic performance is “good enough.” If voters are a lot more bothered by the high price level than they are pleased about the ease with which workers can get a job, well, that’s how they feel. Politicians should try to adjust the economy to voters’ preferences; I doubt telling them they should feel differently is likely to achieve much.

That said, I had been a bit puzzled by the way public sentiment has changed over the last few months.

The University of Michigan Consumer Sentiment Index was rising going into the summer, and then it fell continuously from July to November, dropping from 71.5 to 60.4. During this period, Joe Biden’s poll standing against Donald Trump significantly (and, I believe, relatedly) deteriorated. I don’t find it hard to understand why a voter would be dissatisfied with the economy this year; I do find it a little hard to understand why a voter would have been more dissatisfied with the economy in November than they were in July. Over the intervening period, most economic measures improved (inflation, gasoline prices, GDP growth) or stayed similar (unemployment). The one major economic indicator that got worse over this period was interest rates — the average rate on a new 30-year fixed rate mortgage rose from 6.8% at the beginning of July to 7.8% at the beginning of November.

So maybe interest rates are the story — we talk obsessively about inflation, but inflation and interest rates are both drivers of how cost-burdened consumers are. Consumer payments for non-mortgage interest — mostly, interest on credit cards, auto loans, and student loans¹ — have more than doubled since the Fed started raising rates in early 2022, a fact that doesn’t even show up in inflation measures, because interest payments aren’t considered consumption and are not a component of the Consumer Price Index. Because mortgages mostly have fixed interest rates, existing mortgages haven’t been getting more burdensome for consumers (in fact, inflation has reduced the effective burden of existing mortgage debt) but if you want to buy a house or refinance to access your home equity, you’re in for quite a bit of pain.²

But since the Fed appears to be done raising interest rates (more on that in a moment), November was probably the absolute worst month we’ll experience in a while in terms of burdens on the public from interest rates. And as mortgage rates have fallen sharply from November into December, coming back down to 7.0% in the first week of this month, we see a sign that the vibes are already improving — UMich Consumer Sentiment for December bounced back up to 69.4, nearly as good as it had been in July. Maybe that effect will show up in the political polling soon too.

Dall-E 3 image generation for “central bankers creating good vibes”

If you ask voters whether interest rates are their primary economic concern, very few say yes. This was clear in the Blueprint polling I wrote about a few weeks back: 64% of voters say what they most want out of the economy is lower prices for goods, services and gas; just 9% say their top wish is lower rates on mortgages and credit cards. But I’m not sure how finely voters parse these concerns, rather than looking together at their bills for food and fuel and rent and everything else, and the interest charges they’re paying, and maybe at a potential mortgage on a potential new home, and simply feeling that everything is too expensive.

This is where the Federal Reserve comes in. This mortgage rate situation is explicitly of their making: One of the key ways that interest rate hikes were supposed to cool inflation was by putting a damper on consumption, which they did by making consumers feel it’s unaffordable to buy everything they otherwise might, including homes. This has worked, and even though it did not push the economy into recession, it has caused a lot of pain and annoyance for consumers. The flip side is that as interest rates start to come down, consumers’ ability to afford things should improve, and they might feel better about prices for goods and services even if those prices don’t actually fall. Indeed, as a wrote a few weeks ago, the general price level does not and will not fall, as much as consumers might like it to — but interest rates can fall and are falling, which might prove to be a pretty good substitute, in terms of vibe-improvement.

The main problem with this approach is that cutting interest rates prematurely could cause prices to rise. But Fed officials are now signaling that they believe they can stop tightening monetary policy, and soon start loosening it, without causing inflation to spike.

At this week’s meeting, they declined to raise rates, and their explanation of why they didn’t raise rates makes clear that they probably won’t raise them any further. Fed officials also expressed, in the Summary of Economic Projections, that they believe they are likely to cut the Federal Funds Rate by 0.75% next year. The financial markets are more optimistic than that, pricing in 1.50% of rate cuts. Those expectations of lower short-term interest rates in the future are having effects right now on longer-term interest rates, including mortgage rates — they fell over the last month in anticipation of the Fed’s loosening actions, and they’ll likely fall more now that the market seems to have been impressed with what the Fed did and said today. And that means that the prospect of shopping for a new house is likely to continue getting less grim than it was in early November.

One other consequence of falling interest rates is that stock prices rise. I wrote a couple of months ago about the reverse of this — how rising interest rates were a factor that was depressing the stock market even though the economy as a whole looked pretty good. As rates fall, we should see that effect unwind, and indeed we are: today, the Dow Jones Industrial Average set a record high as bond yields fell. Higher stock prices should be good for vibes, too: As voters are less burdened by interest charges and less shocked by the mortgage payments associated with new home purchases, they’ll also see higher balances in their brokerage accounts. People should feel wealthier because they’ll be wealthier — they’ll be more easily able to afford stuff.

Of course, there’s no guarantee that the financial markets will continue to cooperate like they did today, nor is there a guarantee of how economic effects will flow through into politics. In 1992, the economy looked quite good on paper. Real GDP growth was 3.5%. The Federal Reserve repeatedly cut rates through the year. But both mortgage rates and stock prices were frustratingly stagnant, and voters never gave George H.W. Bush credit for the turnaround from the recession that ended in 1991. The “vibes” did not improve along with output. Biden will need the sort of economic changes that are likely to flow through as vibes — that is, falling interest rates for consumer debt (including mortgages) and rising stock prices. Today’s market moves were a signal that the Fed’s shift toward rate cuts is likely to flow through in this way, but there’s a lot farther for mortgage rates to fall before I expect the “vibes” will start to feel very good.

Very seriously,

Josh

1. One driver of the rising burden of student loan interest has been the end of the years-long pandemic-driven pause in student loan interest accrual and repayment repayment. Most student loans are fixed-rate, but a resumption of interest and payments constitutes a rise in interest costs from a period when the effective interest rate was zero. But as Joseph Politano notes, the restart of student loan interest accounts only for about 12% of the total rise in the burden of non-mortgage interest since the Fed started raising rates early last year; then, on top of that, you have the sticker shock that people face when they try to take out a mortgage. All of which is to say, high interest rates are a problem that is causing pain broadly across the electorate, and interest burden shouldn’t be thought of as particularly a student-borrower political issue.

2. As someone who’s trying to take out a mortgage loan right now, I can attest that my personal attention to mortgage rates is a lot higher than it was this summer, and the “vibe” I have been getting from the prospect of paying the prevailing interest rate on a new mortgage has been bad.