The United States is still stimulating its economy with Covid-era policy

Australia, Canada, and New Zealand are not

The economic performance of the United States in the past year has been exceptional compared to Australia, Canada and New Zealand.¹

Here’s why.

The United States is still stimulating its economy with Covid-era monetary policy because of its unique mortgage market with 30-year fixed interest rates.

Manipulating the price of mortgages and via this, housing investment and prices, is the main way we manage the macroeconomy.

We call it monetary policy.

The basic economic idea is that we need households to spend more money to combat a downturn in the macroeconomy. One way to relax the budget constraint of households is to lower interest rates. Doing so reduces mortgage payments for some households and financing costs for buying new homes (and cars and other durable goods) for all households. This extra spending stimulates economic production activity.

Other non-housing effects happen when we change nominal interest rates, or what we call transmission mechanisms. These include effects on business investment decisions which are moderated via the price of borrowing.

One important side effect of monetary policy is that asset prices are tied to interest rates, particularly housing assets, where debt financing is common and risks are relatively low. When interest rates go down it means you can rent money from the bank as a mortgage for a lower cost than renting a home from a landlord. So people do it! When everyone does it, that pushes up housing asset prices.

This is exactly what happened globally during the 2020-2022 Covid panic. I predicted at the time that home prices would rise, despite widespread commentary that they would crash due to economic disruption.

Central banks worldwide have now reversed that policy, raising interest rates to tighten households' budgets and reduce their spending.

But different financial setups in different countries mean that raising interest rates affects household spending quite differently and hence the same interest rate change is more contractionary in some places than others.

This is why currently there is such an economic boom in the United States more so than peer nations with similar monetary policy settings.

The difference is the 30-year fixed-rate mortgage.

When interest rates are lowered, existing mortgage holders can refinance at lower interest rates, which relaxes the budget constraint of households as it does in Australia with our variable rate mortgages.

But when interest rates are raised, this does not constrain the budgets of existing mortgage holders whose repayments are unchanged because of the long fixed rates. There is an asymmetry in monetary policy transmission in the United States that doesn’t exist in Australia.

The chart below shows how few fixed-rate mortgages exist in Australia, at around 15% of mortgages, relative to the United States (~95%) and countries like France (~93%), Belgium (~92%), Germany (~90%) and Mexico (~100%). Australian fixed-rate mortgages are also much shorter in duration, typically 2-4 years, whereas 30 years is the most common in the United States.

Source: https://www.imf.org/en/Blogs/Articles/2024/04/08/housing-is-one-reason-not-all-countries-feel-same-pinch-of-higher-interest-rates

This matters. There are $2.2 trillion worth of outstanding mortgages in Australia. Every additional 1% point higher interest rate reduces spending power by $22 billion per year from mortgaged households. These households are likely to spend most of their budget and be saving little. That 1% point higher interest rate gives back most of this amount to bank deposit holders, but these households are holding long-term deposits because they want to save money, not spend it.

So the 3% increase means a decent share of $66 billion less in consumer spending compared to the same interest rate rise if outstanding mortgages all had fixed interest rates.

The data shows that an extra 5% of household income is now used to service debts compared to 2021, up from 13.5% to 18.5%. But this figure has fallen in the United States and almost no change in Germany.

Despite rising interest rates, the asymmetric transmission of monetary policy in the United States means it still has an expansionary monetary policy position, unlike countries such as Australia, Canada, and New Zealand. They also have quite a few fiscal policy programs now being enacted.

These smaller nations with more interest rate-sensitive mortgage markets are likely to see the heat come out of their economies much faster than the United States. Consumer spending is likely to fall sooner, with accompanying increases in unemployment. Perhaps this will lead to lower domestic inflationary pressure.

What then?

The likely reaction will be to lower interest rates.

One risk is that if these small nations start lowering their interest rates, their currency values will decline as traders seek to hold more USD relative to lower interest rate currencies, leading to more inflationary pressure on imported goods and things like petrol, which are very visible to consumers.

An alternative is to use more fiscal policy—perhaps build some public housing. But fiscal policy can be slow. Cash grants are a faster alternative to relax the budget constraint of households.

Whatever we do, these differences in how each country’s economy reacts to the same policy settings matter in understanding economic trends. They also matter when thinking about how to manage macroeconomic cycles as a small nation in a globally connected economy where one of the major economies has an asymmetric transmission of monetary policy relative to its peers.

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NOTE: This article explains important differences in how inflation is measured in Australia versus the United States which is also still relevant.

Mysteries of inflation measurement

ICYMI: Thanks to paid subscribers I can do things like speak to the students in the Economics Olympiad about careers in economics and housing markets. Watch that conversation below.

1. This has been a little surprising since these three countries have had huge immigration programs in recent years, which are widely thought to boost economic activity.