Why Haven’t Recent Rate Increases Slowed the Economy More? Look to Unusually Low Private-Lending Spreads

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Inflation spiked in 2021 and persisted into 2022, leading the Federal Open Market Committee (FOMC) to increase the federal funds rate from near zero in February 2022 to 5.25 percent in August 2023. Given experiences in historical tightening episodes, policymakers expected an economic slowdown, but the economy remained resilient. For example, at the end of 2023, unemployment was only marginally higher than before the FOMC began policy tightening.

Why haven’t higher rates slowed the economy more? One possible explanation is a rise in the neutral rate, defined as the interest rate that would prevail if inflation was at target and economic growth at its potential. If the neutral rate rises at the same time as the policy rate, then the difference between the two rates, or the stance of monetary policy, would be unchanged and economic activity unaffected. However, another possible explanation for why rate hikes haven’t slowed the economy is that higher policy rates have not passed through to the rates paid by private firms and households as much as usual. If the spread between the policy rate and the rate charged to firms and households is lower than usual, then borrowers are unlikely to feel the full effect of policy tightening.^_

Private-lending spreads have indeed fallen since the onset of monetary policy tightening in March 2022. Chart 1 shows private-lending spreads relative to the two-year yield on U.S. Treasury securities (our proxy for the short-term policy rate) for both households (conforming 30-year fixed-rate mortgages) and firms (AAA and BAA rated corporate bond yields). From March 2022 to June 2024, spreads fell by more than a percentage point for firms (blue and purple lines) and by 0.5 percentage point for households (green line). Declining spreads have offset higher policy rates, so private-lending rates have risen by less than the policy rate. For example, if the BAA spread had remained constant, BAA yields would have risen roughly 4 percentage points; instead, yields have risen by less than 3 percentage points. As a result, borrowers have likely pulled back less than they would have if spreads had remained constant (or increased).

Chart 1: Private-lending spreads have fallen since the onset of policy tightening in March 2022

Although private-lending spreads may explain why borrowers haven’t been deterred by rate hikes, the economy can be resilient to higher rates for other reasons, such as lower default risk. If households and firms have substantial cash buffers, for example, then borrowers may be less likely to default on loans and thus pay lower spreads. In this case, spreads may be falling in response to policy being unrestrictive, rather than policy being unrestrictive because spreads are falling.

To account for the potential role of default risk in lowering spreads, we examine the “excess bond premium” as introduced by Gilchrist and Zakrajšek (2012). The excess bond premium first measures the spread between a firm’s outstanding corporate bond yields and similar maturity government debt, then subtracts an estimate of that firm’s probability of default and averages this risk-adjusted spread over all firms. In this way, the excess bond premium controls for changes in default risk: a positive premium means the average corporate bond yield is higher than we would expect based purely on risk adjustment, while a negative premium means the opposite.

Chart 2 shows that the excess bond premium marginally increased early in the tightening cycle but has been roughly constant and low since mid-2022. Thus, while the excess bond premium has not dampened the effects of higher policy rates, it has not amplified them, either.

Chart 2: The excess bond premium, which controls for default risk, has remained low

A low excess bond premium is surprising, as historical evidence suggests that the excess bond premium typically rises substantially in response to monetary tightening. Chart 3 estimates how an unexpected 25-basis-point contraction in monetary policy typically affects the excess bond premium as well as the stance of monetary policy (here, our proxy for the short-term policy rate minus a proxy for the neutral rate). Positive values indicate that the variable is higher than it was before the shock. In contrast to its behavior during this tightening cycle, the excess bond premium (green line) typically rises significantly and persistently following a monetary contraction. Furthermore, this increase is usually larger than the increase in monetary policy’s stance (purple line) because the neutral rate typically rises to offset a higher policy rate. In this sense, it is unsurprising that monetary policy’s stance has risen less than policy rates since 2022, but the low excess bond premium has truly defied expectations.

Chart 3: Historically, a contractionary monetary policy shock raises risk-adjusted lending spreads

In summary, recent monetary policy tightening appears to have been less restrictive than expected largely because private-lending spreads have been unusually low. The excess bond premium usually rises sharply and persistently following a monetary contraction and slows economic activity: Gilchrist and Zakrajšek (2012) estimate that an increase in the excess bond premium significantly reduces growth and inflation. However, the excess bond premium has remained low during the current tightening cycle. Understanding why the excess bond premium is low and whether policy has played a role is important not only for predicting the effects of future tightening, but also for understanding how expansionary potential rate cuts will be. Because spreads did not increase during monetary policy tightening, they may not decrease as much as expected during loosening, which may require policy recalibration.