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It seems that the Federal Reserve is tightening its monetary policy. But is it really?
After its last political meeting on Wednesday, the Fed has now raised its interest rate target by two percentage points since the end of 2015. It has reduced its balance sheet by about 6% since passing its quantitative easing to its "quantitative tightening". year.
In June, the Fed dismissed the wording that it would keep rates "below what should prevail over the long term," and the latest statement removed the recurring reminder that "the stance of monetary policy remains accommodative ". According to forecasts, "an appropriate monetary policy" would slow down the economy.
Nevertheless, it is not clear that the central bank has tightened monetary or financial conditions. Many measures even imply that they have indeed relaxed their policies in recent years. This could have important implications for the Fed's future actions and, potentially, for the risk of inflation.
There is no single way to determine the direction of monetary policy. The simplest is to look at short-term interest rates. This is misleading, however, as it does not take into account the impact of Fed bond purchases or its "forward-looking forecasts" on the future trajectory of the policy. The Federal Reserve used these tools to revive the economy while it was weak. As the recovery progressed, things reversed.
An increasingly popular approach is to estimate a "benchmark rate" that incorporates these factors. Jing Cynthia Wu, of the University of Notre Dame, and Fan Dora Xia, of the Bank for International Settlements, claim that the Fed has already tightened its policy by the equivalent of 5.1 percentage points since the May 2014 inflation rate hike.
According to the Federal Reserve Bank of New York, this low corresponds to the date on which the Fed's balance sheet absorbed most of the interest rate risk. The New York Fed also estimates that the balance sheet has actually been reduced by about 20% since then. Another model, developed by Leo Krippner of the Reserve Bank of New Zealand, implies that the central bank has actually raised its policy rate by 7.8 percentage points since the eve of the "tapier fantasy" of April 2013.
The big withdrawal
The Federal Reserve Domestic Securities Portfolio
Total, normalized by duration
Securities backed by mortgages
Securities backed by mortgages
Total, normalized by duration
Securities backed by mortgages
Total, normalized by duration
These estimates are an improvement, but they do not provide information on the direction of monetary policy either. The context matters. The Fed is generally accused of tightening its monetary policy during the Great Depression, despite the fall in the three-month US Treasury yield rate, which went from 5% in 1929 to 0% in 1932. From many economists believe that the solution is to compare rates their theoretical level "neutral" or "natural". Rates above neutrality mean strict policy, while below-neutral rates imply relaxation. Fed Vice President Richard Clarida and New York Fed President John Williams both believe in this approach.
While this may have a conceptual meaning, there are two important issues. First of all, nobody knows where the neutral is. More fundamentally, the theory of the neuter attributes too much importance to one of the least economically significant asset prices in the economy: the risk-free rate in the short term.
Most household debt, for example, comes from long-term mortgages. In addition to growth and inflation estimates, interest rates for these loans include default risk compensation and the possibility that borrowers will repay their loans sooner. Corporate debt also combines credit risk, inflation risk and duration risk. The stock market, which is important for both household wealth decisions and business investment, is at best indirectly linked to changes in the central bank's policy rate.
Change in effective performance of the CCC rating
Debt plus equity minus cash and cash
equivalents divided by net functioning
US non-financial surplus
business sector
corporate debt since the Fed's first rate hike
14 (business value / Ebitda ratio)
Sources: Bureau of Economic Analysis; Federal Reserve
Sources: ICE BAML via the Federal Reserve Bank of Saint-Louis;
Board; Barron's calculations
Debt plus equity less cash and cash
Effective performance change on CCC rated countries
corporate debt since the Fed's first rate hike
equivalents divided by net functioning
US non-financial surplus
(Business Value / Ebitda Ratio)
Sources: Bureau of Economic Analysis; Federal Reserve
Sources: ICE BAML via Federal Reserve Bank of St. Louis;
Board; Barron's calculations
Debt plus equity less cash and cash
equivalents divided by net functioning
US non-financial surplus
(Business Value / Ebitda Ratio)
Sources: Bureau of Economic Analysis; Federal Reserve
Board; Barron Calculations
Effective performance change on CCC rated countries
corporate debt since the Fed's first rate hike
Sources: ICE BAML via the Federal Reserve Bank of Saint-Louis;
This has important implications. Since the Fed officially began raising its key rate, corporate borrowing costs have plummeted and corporate valuations have moved closer to record highs. From this point of view, it seems that the Fed has relaxed rather than tightened. The New York Fed's "Underlying Inflation Gauge", which is heavily influenced by financial variables, suggests that inflationary pressures are at their highest level in decades.
A recent speech by Federal Reserve Governor Lael Brainard suggests that she shares this point of view, even though she describes it differently. In his view, the continued strength of the labor market and the "relatively high level of current asset valuations" – despite rising Fed rates – imply that "the short-term neutral rate has increased." In other words, the Fed could have tightened much more to achieve the desired results by its officials.
Ironically, the reason seems to be that traders have become more confident that the central bank will achieve its goals. This reduces uncertainties about the future and mechanically increases asset prices by lowering risk premiums. According to estimates by economists from the US Federal Reserve Minneapolis, the uncertainty surrounding the five-year inflation outlook has halved since the beginning of 2013, while uncertainty about the # The evolution of the Fed's policy remains close to its lowest level before the financial crisis.
This suggests that Jerome Powell & Co. might consider abandoning their thoughtful and progressive approach. Injecting a bit of ambiguity and enthusiasm could be more effective in mitigating financial excesses and controlling inflation than constantly increasing rates and gradually reducing the balance sheet.
Write to Matthew C. Klein at [email protected]
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