Author: Alp Simsek, Professor of Finance at Yale School of Management
Translation: Tia, Techub News
Editor's Note:
In the current global economic landscape, the Federal Reserve's monetary policy is under unprecedented scrutiny. Despite policy rates reaching historical highs, the U.S. economy remains robust, a phenomenon that seems to contradict traditional economic theory. The ongoing strength of the labor market and steady economic growth raises the question: why has tight monetary policy failed to curb economic overheating as effectively as in the past? Recent research suggests that this phenomenon is not a paradox but rather a limitation of traditional analytical frameworks. By re-examining the impact of financial conditions on the economy, we can gain a deeper understanding of the actual transmission mechanisms of monetary policy.
The Federal Reserve has raised interest rates to historical levels, yet the economy continues to rise. The current strong employment reports are evidence of this. Why is this happening?
According to our latest paper, it may be because we are focusing on the wrong indicators.
While policy rates are high, the financial environment is actually quite loose. The rise in the stock market and the tightening of credit spreads effectively offset much of the Fed's tightening policy.
Data shows that the Fed's own FCI-G index (a composite financial variable designed to measure its impact on economic growth) confirms this. Although long-term interest rates are rising and the dollar is strengthening, the positive market performance (mainly the stock market boom and improvement in credit spreads) is stimulating economic growth.
Tight monetary policy and strong growth are not, in fact, a paradox.
Our research with Ricardo Caballero and @TCaravello indicates that what matters for the economy is not the policy rate itself, but rather the broader financial conditions.
Our analysis shows that when financial conditions are relaxed, even if driven by noisy asset demand (sentiment), it can stimulate output and inflation, ultimately forcing interest rates to rise. This aligns with the situation we see today.
From a quantitative perspective, the research found that the impact of financial conditions on economic output fluctuations accounts for as much as 55%.
Moreover, the primary transmission mechanism of monetary policy should be to influence financial conditions, rather than acting directly through interest rates.
The current situation fits this framework: despite high interest rates, loose financial conditions are supporting strong growth and may prevent inflation from returning to target levels.
Looking ahead, this suggests that the Fed's job is not yet done. To achieve the 2% target, financial conditions may need to tighten.
This could be achieved through the following means: market adjustments - a stronger dollar - further rate hikes.
The path of interest rates will largely depend on market dynamics. If the market adjusts and the dollar strengthens, the current level of rates may be sufficient. However, if financial conditions remain loose, further rate hikes may be necessary.
This framework suggests that Fed observers should focus less on the debate over the "terminal rate" and more on the evolution of financial conditions. This is where the real transmission of monetary policy occurs.
While our paper further proposes a clear FCI target, more importantly, we need to change the way we think and talk about monetary policy. The policy rate is just an input; financial conditions are what truly matter.
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