The word resilient has become every headline writer’s go-to adjective for describing the economy this year. GDP growth exceeded 2% in the first half, and employment has grown by well over 300,000 per month. This is a surprising outcome in light of the Federal Reserve’s program of tightening monetary policy and reflects an unusual development—the easing of financial conditions since last fall.
The Fed and Monetary Policy
Monetary policy is usually transmitted by the financial markets, including the bond and stock markets. Residential investment and house prices also play an important role. So do foreign exchange markets, which have an effect on exports and imports. A review of these key transmitters of monetary policy shows something very unusual. They operated in the usual way for most of last year but beginning around October started working against the Fed’s efforts to slow down the economy.
Long-term interest rates, including mortgage rates and investment-grade corporate bond yields, peaked in late October or early November. Investment-grade corporate bond yields, a key determinant of the cost of tapping financial markets to finance new investment, are down by over 50 basis points since early November. Mortgage rates are also down since then.
This has helped to stabilize interest rate-sensitive sectors of the economy, especially housing. After falling for most of 2022, housing activity (including house prices) has stabilized. Indeed, there are hints of a rebound in some of the house price data. This has provided support to consumer spending via the wealth effect.
Household wealth has also benefited from a turnaround in the stock market. After falling in the first three quarters of 2022, equity prices have staged a rebound. The S&P 500 is up 28% from its low point in mid-October. The NASDAQ is up 37% from its low, helped by bullish sentiment about the implications of new artificial intelligence applications.
The value of the dollar against other currencies usually rises when the Fed is tightening monetary policy. This, in turn, depresses net exports and helps to slow down the overall economy. For most of 2022, the dollar followed the textbook pattern by appreciating. However, this too changed abruptly last fall, and the dollar has fallen about 10% against other major currencies since the end of the third quarter.
Energy prices have fallen significantly since the middle of last year, reversing most of the increases in the first half of 2022. This has also contributed to the resiliency of the economy.
The banking sector did tighten lending standards after a pair of bank failures this spring. However, this only provided a partial offset to the easing of credit conditions described above.
Why did credit conditions ease over the past three quarters, a time when the Federal Reserve’s Open Market Committee (FOMC) raised the Fed funds rate by a total of 225 basis points? One explanation is that these rate increases largely validated expectations already priced into the markets. In 2023 the Fed has tightened by only slightly more than it signaled in late 2022 that it would be doing. If the Fed wants financial conditions to tighten, it will have to find a way to change market expectations.
Looking forward to 2024, the market is currently anticipating some reductions in the Fed funds rate. The FOMC has encouraged this view through its own forecasts of the future path of the Fed funds rate.
This gives it an opportunity to tighten financial conditions simply by not validating market expectations of rate cuts in 2024. It can achieve this by keeping rates higher for longer, a theme we emphasized in last month’s column.
The economic data released in the past month have reinforced our view that this is the most likely outcome for 2024. Such an outcome would reflect the economy’s resilience, which in turn is a by-product of the somewhat surprising easing of financial conditions we have seen since last fall. We expect progress in bringing down inflation to continue to be slow. This too will work to keep the Fed funds rate higher for longer in 2024 and perhaps beyond.
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