The paradox of “restrictive financial conditions”


The Fed often explains the monetary policy transmission mechanism as follows:

Tighter money results in more restrictive financial conditions. This reduces the growth rate of aggregate demand, and eventually slows inflation.

Now let’s suppose that the Fed is expected to achieve its goal of slowing demand at exactly the right pace to achieve a soft landing. They are seen as “threading the needle”. Markets respond with a burst of optimism. Stocks rise on expectations of no deep recession, and long-term interest rates fall on expectations of inflation falling back to 2%. Does this sort of optimistic market reaction undo the “restrictive market conditions” required to achieve the necessary slowdown in demand?

In other words, can good news be bad news, and vice versa?

Long time readers know that I will invoke “never reason from a price change” in this post. We need to be very careful in drawing conclusions from any change in asset prices. But here are some general principles:

1. Some asset markets, such as stocks and industrial commodities, are more closely linked to movements in the real economy.

2. Other asset markets, such as long-term bonds and TIPS spreads, are more closely linked to movements in the nominal economy.

3. Short-term interest rates are especially unreliable.

Ideally, the Fed would like to see NGDP-oriented indicators slowing, while RGDP-oriented indicators continue to do OK. Thus a rising stock market does not, by itself, mean that monetary policy is becoming too expansionary to slow demand. it might mean that, but you’d have to look at other indicators to have confidence in that conclusion.

My read on the last month or two of data is that most of the increased market optimism related to the real economy. (I’m not convinced we’ll avoid a sizable recession, I’m just saying that the market seems increasingly optimistic on that score.) Inflation indicators continue to suggest that the rate of PCE inflation will fall back to about 2% in a few years.

Don’t view this post as a forecast. View it as a way of interpreting co-movements in a variety of markets. I expect we will see plenty more ups and downs in the markets over the next 12 months, and I’m suggesting that this is the best framework for interpreting the various data. Policy may end up overshooting in one direction or another, but right now it seems roughly on track. (As of today, I’d recommend 75 basis points in September, but I might change my mind before the meeting.)

So don’t be swayed by pundits that tell you the recent stock market rally makes the Fed’s job that much harder. The recent rally is an indication that the Fed’s job might not be quite as difficult as we assumed in June.

Or the markets might be wrong. . . again.

PS. Here’s an article in The Economist that seems to rely on the definition of restrictive financial conditions that conflict real and nominal growth indicators:

Concerns about inflation only add to the market’s importance. When share prices rise, consumers, feeling flush, tend to spend more money and companies, feeling confident, tend to hire more workers. A paper in 2019 by Gabriel Chodorow-Reich of Harvard University and colleagues concluded that each dollar of increased stockmarket wealth lifted consumer spending by about three cents annually, while also boosting employment and wages. For a central bank fighting inflation, a large rise in share prices would therefore cut against its efforts.

This makes for borderline hypocrisy in Fedspeak. Sober central bankers can explain that they want “appropriate firming of monetary policy and associated tighter financial conditions” to help rectify the supply-and-demand imbalances that are fueling inflation (as the Fed did indeed say in the minutes of its rate-setting meeting in June). Yet it would be beyond the pale for them to declare that they want “appropriate firming of monetary policy and associated weaknesses in the stockmarket”—even if their meanings are closely aligned.

Actually, they are not always closely aligned.

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