The Fed has reduced its balance sheet holdings by around $800 billion, which has put pressure on savings deposits. That’s because the Treasuries and mortgage-backed securities the Fed used to hold now have to be financed with bank deposits or other kinds of money. Banks have mainly responded to the drop in deposits by raising new funding through things like large time deposits, by selling financial assets, and by slower lending, according to Goldman Sachs Research.
However, tighter credit is only one of several ways banks have responded to the decline in deposits, and the decline in the monetary aggregates over the last year doesn’t translate dollar-for-dollar to a decline in lending and is not a good way of estimating the impact on lending and investment, Abecasis writes.
Our economists say a better way to estimate the impact of tighter monetary policy and financial conditions on the economy is by using market prices and interest rates rather than quantities such as M2. They say there’s a more robust statistical link between changes in Goldman Sachs Research’s broad financial conditions index and GDP growth, which for example captures the effect of higher interest rates on homebuilding or the effect of lower asset prices on consumer spending.
Market prices directly influence trade-offs between consumption and savings, and they are immune to the changes in how monetary policy is implemented and other ad-hoc definitional changes that can cause big changes in monetary aggregates that have little relevance for economic activity. Goldman Sachs Research finds that this approach also has a stronger predictive track record, and it avoids the common mistake of assuming a fixed mechanical link between reserves and lending or deposits and spending.
Using that framework, our economists expect the tightening in financial conditions and bank lending standards to cause a drag of 0.3 percentage points on GDP in the second half of 2023, a decline from the 1.2 percentage-point drag in 2022 when the financial conditions index tightened sharply as the Fed turned hawkish.
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