Monetary Policy Cycle
The Monetary Policy Cycle
Data on this page was last updated on May 18, 2023
The Federal Reserve’s monetary policy often influences the rhythm of the business cycle. The monetary policy cycle shapes the business cycle. Likewise, the business cycle feeds the monetary policy. You can loosely view this relationship by plotting the fed fund rate next to the GDP output gap. The GDP output gap is how we monitor the business cycle and the growth of the U.S. economy.
Throughout an expansion, the yield curve flattens. The Federal Reserve raises short-term rates faster than long-term rates rising until the yield curve inverts and eventually precipitates a recession at the extreme of maximum monetary restrictiveness. This extreme in monetary policy restrictiveness occurs when inflation has become a problem and much less slack in the labor markets. As the recession worsens and the inflation rate falls, the monetary policy usually rushes to cut short-term rates, and the cycle begins anew. Generally, monetary policy is most stimulative in the first phase of expansion, when inflation is low and unemployment high.
Think of the monetary policy cycle as a pendulum swinging between accommodation and tight policy. It represents the change from a restrictive Federal Reserve policy, causing a recession to be accommodative, digging us out of a recession. The inflection point in this cycle is when the policy reaches either max accommodation or maximum restrictiveness.
Because monetary policy is directly linked to the economy’s performance, understanding monetary policy becomes a must for asset managers like us. Understanding the Federal Reserve is a tall task to complete. They are elusive and complex, but knowing what their responsibilities (mandates) are and what influences them (feedback loops) unlock the keys to understand them. Let’s start with the mandates from Congress that grant them authority over the money system of the United States.
Dual Mandate
The current mandate of the Federal Reserve first made its way into the Federal Reserve Act in November 1977. The 1970s were plagued with high inflation and unemployment, a severe adverse macroeconomic condition known as stagflation, which motivated Congress to reform the original Act of 1913. To clarify the Fed’s Board of Governors and the Federal Open Market Committee’s (FOMC) roles, Congress’s Reform Act explicitly identifies “the goals of maximum employment, stable prices, and moderate long-term interest rates.” {citation needed} These goals have become known as the Fed’s “dual mandate.”
The first thing to notice is that the so-called dual mandate actually appears to be a triple mandate of achieving the following three goals: Maximum employment, stable prices and moderate long-term interest rates.
Maximum employment stands on its own as a single mandate, while the other two are grouped to form the second mandate. Having just combined the goals of stable prices and moderate long-term interest rates into a single order, it may be surprising to realize that as of January 2012, the FOMC claimed that achieving its dual mandate is consistent with targeting an inflation rate of two percent. This sounds more like a single mandate, which is why one can interpret the Fed’s goals as compatible with the European Central Bank’s (ECB) single mandate of maintaining price stability.
Feedback Loops
The dual mandate creates feedback loops for economic growth, labor market, and wage growth.
A feedback loop is when the outcome of one thing causes another. When we talk about monetary policy feedback loops, we discuss how low unemployment causes price instability (inflation). Lowering inflation includes slowing the economy, which causes a rise in unemployment. Both of which are the dual mandates for the Federal Reserve.
Recessions occur when the Federal Reserve over tightens their policy while trying to slow inflation. Likewise, inflation occurs when the Fed is too accommodative. Of course, external factors are out of the control of the Federal Reserve, like the pandemic or Fiscal Policy. In part 2 of this series, I will discuss the Federal Reserve’s tools to manipulate inflation and employment. But for now, all you need to know is the Federal Reserve’s primary tool is controlling the cost of money in the form of short-term interest rates known as Federal Funds Rates.
Monitoring Feedback Loops
The Federal Reserve has a tough time managing these two mandates because they have feedback loops. When the labor market is tight, and there is a lack of workers to meet demand, wages go up. Rising wages are not a direct cause of inflation, but when wages rise faster than productivity, that is wage inflation. When wage inflation increases, the price of goods usually increases as well. Rising inflation causes the economy to run too hot, which tends to encourage the Federal Reserve to become more restrictive.
Wage Inflation
Wage inflation depends on the excess of wage growth over the growth rate of labor productivity. We calculate wage inflation by taking average hourly earnings (wage growth) and subtracting the long-term average of labor productivity. Below, you can see the Fed Fund Rate (FFR) relationship and wage inflation.
Notice how the effective Fed fund rate reacts to wage inflation. It is helpful to note that once interest rates hit zero in 2008, the Federal Reserve used quantitative easing as an additional accommodation measure. This continued until 2013, when wage inflation finally bottomed reaching maximum accommodation.
This relationship held true up until the current Covid-19 pandemic when fiscal stimulus caused wage inflation to get out of control. The Federal Reserve did not react soon enough to the increase in inflation breaking the normal relationship between monetary policy and wage growth. This caused inflation to spike while unemployment rapidly recovered. I think the Federal Reserve failed its price stability mandate by focusing on the labor market and ignoring the mass amount of stimulus.
The Labor Gap
There is an inverse relationship between the size of the output gap (the percentage difference between GDP and potential GDP) and the size of the unemployment gap (the difference between the unemployment rate and the natural rate of unemployment). According to that relationship, actual output exceeds its potential level when the unemployment rate is below the “natural” rate of unemployment; real GDP falls short of potential when the unemployment rate is above its natural rate.
For the natural unemployment rate, we estimate the non-accelerating inflation rate of unemployment (NAIRU). That rate corresponds to a particular notion of full employment, the rate of unemployment that is consistent with a stable rate of inflation. The historical estimate of the NAIRU derives from an estimated relationship known as a Phillips curve. This connects the change in inflation to the unemployment rate, among other variables, including changes in productivity trends, oil price shocks, and wage and price controls. The historical relationship between the unemployment gap and the difference in the inflation rate is strong and relatively stable.
Notice how the Labor Gap drops below zero just before a recession. This is because the unemployment rate is below the NAIRU, the labor market is tight causing wage inflation. Monetary Policy then becomes restrictive, usually over doing it leading to recession.
The Phillips Spread
Familiar to investors and economists alike is the Phillips curve, the relationship between unemployment and inflation. It shows that when inflation is high the labor market is tight and when there is slack in the labor market inflation tends to be lower. We think measuring the Phillips curve makes a lot more sense to look at as a spread. To calculate the spread We take the unemployment rate less wage inflation shown below.
If the spread is near two, we believe a meaningful amount of inflation is baked into the economy. If the spread drops below zero, we consider this high inflation similar to the 70s, when stagflation was present.
Okun’s Law
Okun’s Law looks at the statistical relationship between the change in GDP and unemployment. This linear relationship is the glue that holds the feedback loops to the business cycle. Unemployment is linked to the output of a country’s economy. Inflation is lowered by slowing down an economy. therefore, it is reasonable to assume that the feedback loops exist, thus linking the Federal Reserve policy stance to the business cycle.