Policymakers are worried they will not be able to gauge an overshooting of monetary tightening.
Federal Reserve officials are worried U.S. financial conditions could tighten more quickly than expected in response to aggressive rate increases and balance sheet runoffs, potentially compromising economic expansion, former central bank officials and researchers told MNI.
Policymakers are paying close attention to various measures of financial conditions including the stock market, whose sharp recent decline could drag on investment and household wealth, and to an incipient widening of credit spreads, as they seek to gauge how close rates are getting to neutral levels that neither boost nor slow growth and avoid any overshoot in monetary tightening, ex-policymakers said.
“How much tightening you’re getting depends on financial markets -- what does the stock market do, what does credit do? I find it hard to think about (neutral) in terms of a stopping point defined in units of Treasury rates,” said Jeremy Stein, a former Fed governor now at Harvard University, in an interview.
“I would put more weight on credit spreads than the stock market because the evidence I’m familiar with suggests those have more of a causal impact on economic activity. So we’ve started to see some real back up in credit spreads and if you asked me to guess I would think there’s maybe a little bit more to come.”
Minutes from the Fed’s June meeting specifically highlighted “the possibility that a further tightening in financial conditions would have a larger negative effect on economic activity than anticipated” as a key risk.
FORWARD GUIDANCE LIVES
Fed officials are also watching for signs that their increasingly transparent communications may have shortened the delay after which monetary policy is thought to affect consumers and businesses.
“The Fed hopes that its forward guidance about what it intends to do on interest rates is already achieving some desired effects, so if you were looking at indicators like tightening credit conditions, you’re seeing some tightening there,” said Kris Mitchener, a former visiting scholar at the St. Louis Fed and the Bank of Japan, and a professor of economics at Santa Clara University.
“So their hope is that will give them some space in which they can perhaps not raise interest rates as much in order to bring inflation down. It’s unclear whether that is sufficient.”
That hope was underscored in a recent speech from San Francisco Fed President Mary Daly, who argued that the “unprecedented” speed with which financial conditions have tightened in reaction to not just Fed rate hikes but the promise of more “means that long and variable lags may not be as long, or variable, as typically assumed.”
Another 40-year high CPI reading of 9.1% in the year to June has further complicated the picture for Fed officials, who now appear to have even more ground to make against inflation through persistent interest rate hikes.
Daly cited housing as one of the first and most important channels of monetary transmission to consumers. Mortgage rates jumped by more than 200 basis points from March to June.
“The stock market is down, mortgage interest rates are up, various interest rates are going up. The normal ways that monetary tightening reduces asset prices and raises interest rates and discourages borrowing and spending, those are in play,” said Laurence Ball, a former visiting scholar at several central banks including the Fed and the Bank of England.
“In a way this is working like a normal monetary tightening and presumably we’ll see that slowing down the economy somewhat.” (See: MNI INTERVIEW: Housing Cost Lag To Drive Inflation As Fed Hikes)
Sebastian Edwards, former World Bank chief economist for Latin America, noted housing is also one of the slower markets to correct because it involves a tangible asset that is not particularly prone to rapid trades.
“The first thing that happens is that houses stay on the market for longer. People are very reluctant to recognize that their home is not worth what they thought it was worth,” Edwards said. "People look at their 401ks but what they really look at is what they think they have as equity in their house. So we’re going to have to wait longer.”