The Fed has a lot of work ahead of them.
Summary
Measuring the Effective Federal Fund Rate alone is not enough to determine if monetary policy is restrictive or accommodative.
The yield curve continues to be the best indicator for Federal reserve policy but is a long-leading indicator.
Coincident indicators are suggesting that monetary policy is lowering inflation, but inflation remains high.
With both long-leading and short-leading indicators, we can argue that the Federal Reserve has much more to do to bring down inflation. Still, the current economic policy pushes inflation in the right direction.
Last week we discussed the release of CPI data that spurred a rapid market rally and why we did not believe it would change the mind of the Federal Reserve. This week I want to discuss whether the current Federal Reserve Policy is working to lower inflation.
Is monetary policy restricitve enough?
First, let’s set out the goals of this analysis; it is easy to see that Monetary Policy is restrictive. Looking at the current Monetary Policy, one can see that the Federal Reserve is restrictive. This is obvious because of the recent rate hikes with a target range of the Effective Federal Funds Rate (EFFR) between 3.75 and 4.00 percent. The EFFR ranged from 0.25 percent at the beginning of 2022. This makes this rate hike cycle one of the quickest in our history. I want to know whether the current restrictive policy has drained liquidity enough to slow inflation or, do we need a tighter approach to change the direction.
Depending on just the level of EFFR can be a misleading gauge of the monetary policy stance. Just because interest rates are high, it might not be high enough to lower inflation, and likewise, just because interest rates are low does not mean inflation will rise. For example, in 2008, during the great financial crisis (GFC), the Federal Reserve lowered rates to zero, but that alone was not enough to stimulate the economy back from the GFC. To become accommodative enough to turn the ship, the Federal Reserve had to implement quantitative easing. The classic mistake of associating low-interest rates with easy policy breaks down in a deflationary world. This was a significant point made by Milton Friedman and Anna Schwartz in their Monetary History of the United States, which they explained in detail.
To account for this, Laubach-Williams and Holston-Laubach-Williams create a model to estimate the natural interest rate, commonly referred to as R-star. This is the interest rate at which anything above would slow inflation, and anything below would increase inflation. If interest rates were set right at the natural interest rate, then inflation would theoretically stay the same. The issue is that R-star is an estimate, and estimates can be wrong. We need a better way to monitor the impact of monetary policy.
The Bond market is another tool to gauge monetary policy. Instead of comparing the policy rate to r-star, you can compare the policy rate or other short-term rates to long-term interest rates. The yield curve attempts to do just that by taking a long duration and subtracting a shorter-term bond. The most common in this analysis is the ten years less three months, although the ten years less two years is also popular and typically leads monetary policy by about six months to two years.
The yield curve
From an investment perspective, the yield curve is one of the most valuable tools for measuring the thrust of Fed policy. When the yield curve is at its steepest. The policy is most stimulative, with the overnight money market rate determined by monetary policy steepest compared to the long-term Treasury note yield. The policy is tightest when the yield curve is very flat or even inverted, as has been the case just before every recession in the past half-century. In that case, “liquidity” is expensive: short-term rates are high relative to long-term rates.
In late October 2022, the yield curve inverted. Following that inversion, PCI inflation dropped, as mentioned in our post about the Powell Pivot. This is a clear indication that monetary policy is currently considered to be tight and restrictive. But the yield curve tells us little if it is enough or not because of the long-lead time between slowing inflation and the inversion.
Notice how the yield curve leads to inflation by months, sometimes years. This is because it takes a tight liquidity situation sometime before it impacts inflation. This is also why the yield curve is one of the best predictors of a recession. Recessions rarely occur without tight monetary policy, and recessions typically occur during deflation from Fed policy overdoing it.
The lag time from the inversion to inflation dropping is telling us that while Fed policy is tight enough, there may be some time before the policy will make its way through the economy and slow inflation.
Short leading indicators of monetary policy
Because of the lag from the yield curve, another method should be included in the analysis to determine if monetary policy is working. But the question is simple. When the banking system is shrinking, the central bank’s balance sheet is declining, the money growth rate is decelerating, and inflation is falling towards zero, these are the classic signs that policy is too tight regardless of the level of interest rates. If rates are at zero, this scenario cries out for quantitative easing. These indicators provide a glance at the effectiveness of the monetary policy; if they are increasing, then the monetary policy is loose; if they are decreasing, then monetary policy is tight.
Liquidity is tight, and the Federal Reserve Policy is working, are you ready for the outcome?
The lag between inflation and all the inflation indicators is why inflation is so hard to forecast. But we can confidently say that inflation should be headed lower in 2023. The rate might be debatable, but with the money supply, Fed’s balance sheet, and bank reserves all decreasing, the drop in inflation should be substantial. We also know that the Federal Reserve’s primary goal is to control inflation at all costs, suggesting that inflation should come down despite the impact on economic growth. A recession is the likely outcome of this current monetary policy stance.
Be prepared to go through a reasonably deep recession, with the odds of a light recession only possible if the Federal Reserve reverses course soon. How much the market has already priced in is a good topic for another post, so stay tuned.