Demand, credit channel limit US monetary policy tightening effects

A Bank of Japan working paper finds that the U.S. economy's resilience to rapid Federal Reserve monetary policy tightening since 2022 stems from two key factors.

First, the heterogeneity among GDP demand components, termed the 'composition effect,' plays a crucial role.

The analysis reveals that demand components with higher reliance on borrowing, such as durable goods consumption and housing investment, are significantly dampened by rate hikes.

Conversely, components with lower borrowing dependence, like service consumption and intangible asset investments, exhibit muted responses.

This suggests that the growing dominance of service consumption and intangible asset investments in the U.S. economy has attenuated the overall impact of monetary policy on aggregate demand.

The study uses a Factor-Augmented VAR model to examine these heterogeneous effects across approximately 100 macroeconomic indicators.

The paper also highlights a 'regime effect,' where the effectiveness of monetary policy varies with financial market conditions, particularly through the credit channel.

Previous research suggests that monetary policy tightening increases external funding premiums, restraining investment and consumption, especially for borrowing-dependent components.

However, the study confirms that the effects of monetary policy intensify for demand components with higher borrowing dependence only when the credit channel is strongly operative, as indicated by a higher excess bond premium.

Conversely, components with lower borrowing dependence demonstrate weak reactions irrespective of the prevailing financial market regime.

This framework integrates both composition and regime effects to explain the limited downward impact of recent monetary policy tightening on the real economy.