The paradox of “controlled financial conditions”.

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

Tighter money means more fruit Limited financial situation. This reduces the growth rate of aggregate demand and eventually slows inflation.

Now let’s assume that the Fed is expected to achieve its goal of easing demand at just the right pace to achieve a soft landing. They are seen as “needle threading”. The market responded with a burst of optimism. Stocks rose on expectations of no deep recession and long-term interest rates fell on expectations inflation would return to 2%. Does this kind of optimistic market response undo the “constrained market conditions” necessary to achieve the necessary slowdown in demand?

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

Longtime readers know that I will say “not the reason for the price change” in this post. We have to be very careful in drawing conclusions from any changes in asset prices. But here are some general principles:

1. Some asset markets, such as stocks and industrial products, 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 particularly unreliable.

Ideally, the Fed would like to see NGDP-based indicators slowing, while RGDP-based indicators are holding up. Thus a rising stock market does not by itself mean that monetary policy is becoming too expansionary to slow demand. it is may be Meaning, but you have to look at other indicators to have confidence in that conclusion.

My reading of the last month or two of data is that much of the increased market optimism has to do with the real economy. (I’m not sure we’ll avoid a major recession, I’m just saying that the market seems increasingly optimistic on that score.) Inflation indicators are suggesting that the PCE inflation rate will return to around 2% a year. A few years.

Do not view this post as a forecast. See this as a way to explain co-movement in different markets. I expect we will see many more ups and downs in the market over the next 12 months, and I suggest that this is the best framework to interpret the various data. The policy could end up overshooting in one direction or the other, but right now it seems roughly on track. (As of today, I will recommend 75 basis points in September, but I may change my mind before the meeting.)

So don’t be fooled by the pundits who tell you that the recent stock market rally has made the Fed’s job harder. The recent rally is an indication that the Fed’s job may not be as tough as we assumed in June.

Or the market may be wrong. . . again

Rest assured. Here is an article Economist It relies on a definition of restrictive monetary conditions that combines real and nominal growth indicators:

Concerns about inflation only add to the market’s importance. When stock prices rise, consumers, feeling flush, spend more and companies, feeling confident, tend to hire more workers. Harvard University’s Gabrielle Chodorow-Rich and colleagues concluded in a 2019 paper that each dollar of increased stockmarket wealth increased annual consumer spending by about three cents, while boosting employment and wages. For the central bank to fight inflation, a large rise in share prices will therefore counter its efforts.

This makes FedSpeak borderline hypocritical. Sober central bankers can explain that they want “an appropriate tightening of monetary policy and the associated tighter monetary conditions” to help correct the supply-demand imbalances that fuel inflation (as the Fed actually said in the minutes of its rate-setting meeting in June). Yet it would be beyond the pale for them to declare that they want “proper strengthening of the economy and corresponding weakness in the stock market” – even if their finances are closely linked.

In fact, they are not always closely aligned.

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