When monetary policy "tightening" is not what you think

And a view from the stock market

Over the last three decades we can “identify” 5 episodes of monetary “tightening”, understood as instances when the Fed (substantially) increases the Fed Funds rate. The chart illustrates:

Some “tightenings” were steep, as in the first and third bars. The last bar shows that “tightening” (still ongoing) was very steep. Another characteristic shown in the chart is that, except after the first bar, “tightenings” are shortly followed by robust “easings” (the last “tightening” is still ongoing).

The next charts depict inflation, both Core & Headline PCE and unemployment.

Curiosities:

Throughout most of the period, at least until C-19 hit, core inflation was low & stable. During the 1990s, oil shocks were not significant, so core and headline inflation do not show divergence. That clearly changes in the 00s!

With the exception of the first tightening episode, all others take place during periods where oil prices are on the rise. It is maybe fair to conclude that negative supply shocks, like an increase in oil prices, affect the Fed´s disposition to “tighten”.

This is clear from reading the 2008 Transcripts of FOMC Meetings, where Bernanke´s summary of the June 08 meeting (just as oil prices peaked) says it all:

“My bottom line is that I think the tail risks on the growth and financial side have moderated(!). I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern.

We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.”

How ironic! He got the financial stress, high unemployment AND a drop in inflation!

More from FOMC Meetings in 2008 here (lots of absurd pronouncements and one “good call” by departing Governor Mishkin):

What I’d like to spend some time on—because I feel this is sort of my swan song, but maybe because I’m a classy guy, I’ll call this my “valedictory remarks”—are three concerns that I have for this Committee going forward. I’m not going to be able to participate, but I have a chance now to lay them out.

The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policy. This is very dangerous. I want to talk about that.

In all “tightening” episodes (again except post C-19), while core inflation remains contained, unemployment falls! Interestingly, it picks up during the “easing” periods, the exception being post the Dec 93-March 95 ”tightening”, when there was no “easing” to speak of!

In the Sept 94 FOMC Meeting we read:

In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions. In the context of the Committee's long-run objectives for price stability and sustainable economic growth, and giving careful consideration to economic, financial, and monetary developments, somewhat greater reserve restraint would or slightly lesser reserve restraint might be acceptable in the intermeeting period. 

Votes for this action: Messrs. Greenspan, McDonough, Blinder, Forrestal, Jordan, Kelley, LaWare, Lindsey, and Parry and Mses. Phillips and Yellen.

Vote against this action: Mr. Broaddus.

Mr. Broaddus dissented because he believed that a prompt move to somewhat greater monetary restraint was needed at this point. In his view, the current stance of monetary policy was overly accommodative in light of the signs of increasing price pressures and rising inflationary expectations that were associated with the continuing strength of the economic expansion and high levels of capacity utilization. In this situation, a delay in implementing some monetary policy tightening would incur a substantial risk of a further increase in inflationary expectations and could make it more costly to achieve the Committee's longer-term anti-inflationary goals.

It´s hard to see “increasing price pressures”. In fact, inflation was falling and remained on a downtrend all the way to the end of the decade. With unemployment also falling continuously throughout the period, capacity utilization must have been “smoking hot”!

This Phillips Curve way of thinking really does a lot of damage. For example, after the June 2017 FOMC Meeting, about halfway through the 2015-19 “tightening” episode, in the post meeting press conference, Chair Yellen says:

We want to keep the expansion on a sustainable path and avoid the risk that … we find ourselves in a situation where we’ve done nothing, and then need to raise the funds rate so rapidly that we risk a recession. But we are attentive to the fact that inflation is running below our 2 percent objective.

Just a few days later, New York Fed president William Dudley spoke this “pearl of wisdom”:

If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation. Then the risk would be that we would have to slam on the brakes and the next stop would be a recession."

And a few days earlier, Michael Feroli, chief U.S. economist of J.P. Morgan Chase & Co. had said “Other Times Unemployment Has Been This Low, It Didn’t End Well”:

There have been only three fleeting periods in the past half-century when the U.S. unemployment rate was as low as it is today.

This would be cause for celebration but for one disturbing fact: in hindsight, each period was associated with boiling excesses that led to serious economic trouble. Low unemployment of the late 1960s preceded an inflation spiral in the 1970s. The late 1990s bred the Dot-com bubble and bust. The mid-2000s saw the buildup and collapse of U.S. housing.

While there is reason to believe today’s economy isn’t boiling over as in the past, those episodes call for caution. It’s not a matter of superstition, it’s a matter of being mindful of the history of what such a low unemployment rate usually is followed by.

Both Dudley and Feroli must have looked at the unemployment chart and “observed” that when unemployment reaches “low levels”, it spikes up.

Is that because monetary policy didn´t “tighten” enough or “eased” too much or too soon?

The C-19 event led to a “gold medal” high jump in unemployment. Certainly no “boiling excesses” here. Also, inflation only “fast-tracked” up one year after unemployment earned the high jump gold medal and had almost “fallen back to the mat”.

Generally (again excluding the C-19 episode), when monetary policy is in “tightening” mode, core inflation remains stable and unemployment comes down. During the subsequent “easing”, inflation remains contained and unemployment goes up.

It seems something is “wrong” with the definition of “tightening” and “easing” of monetary policy. The conventional appeal to “long and variable lags” may be just an “excuse” to justify the “timing” of events.

There must be another indicator of monetary policy that better defines the “stance” of policy. Fortunately, there is one. It appears aggregate nominal spending (NGDP) growth does a much better job of defining the stance of monetary policy. At least it is consistent!

The chart for NGDP growth:

The 1990s provides a good “control”. Both during and following the “tightening” (1st orange bar), NGDP growth remains quite stable. Inflation remains stable and then falls (positive productivity shock), while unemployment falls throughout. The moves in the Fed Funds rate during those years seem quite “irrelevant” for the outcomes of both inflation and unemployment! In other words, monetary policy was appropriate, with NGDP growth remaining relatively stable.

This contrasts with what we observe after the late 90s interest rate hike. Although the Fed Funds rate was being forcefully reduced, unemployment climbed (with 2001 being designated a recession year).

Note that, despite the drop in rates, NGDP growth fell significantly, leading to the increase observed in the unemployment rate. While NGDP growth remained stable during the so called “tightening” of monetary policy in 99/00, with inflation contained and unemployment falling, the so called “easing” of monetary policy that followed was actually a tightening (no scare quotes) of monetary policy, well defined by the drop in NGDP growth.

The same pattern is observed in the next cycle. While NGDP growth remains stable, despite the increase in rates, core inflation remains contained (with the rise in headline inflation reflecting the strong negative supply shock) and unemployment on a downtrend. When NGDP growth tanks, unemployment shoots up and both headline and core inflation fall.

Alas, while the rise in the Fed Funds rate was, to put it kindly, consistent wih an appropriate monetary policy (stable NGDP growth), the deep fall in the Fed Funds rate was “consistent” with a very strong tightening of monetary policy! No wonder it became known as the “Great Recession”, with real output (RGDP) growth dropping to -5% (YoY) by the time the recession ended in mid-2009!

The period that followed became known as “Secular Stagnation” ( I prefer “Depressed Moderation”). NGDP growth remained stable, although at a significant lower rate. This lower NGDP growth rate explains the protracted drop in unemployment and the lower stable inflation rate.

I´ve already shown some quotes relating to the “absurd” “tightening” move of 2015/19. These absurdities may have led Daniel Tarullo, a former Fed Governor, to write in late 2017: “Monetary Policy Without a Working Theory of Inflation”:

Coming fresh to a place where much of the discourse was accepted or assumed by the very smart economists on the FOMC and the Fed staff helped me to see where some of that received wisdom was not holding-up well in the circumstances we were facing. That perspective also led me to see how some well-worn tools or concepts in monetary policy that rely on unobservable variables had perhaps been less useful even before the onset of the financial crisis…

…In this paper, I will explain two conclusions that I drew from my experience. One is a substantive monetary policy point, and the other is more of a sociological observation relevant to the monetary policymaking process.

The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policy-making.

The sociological point is that many (though certainly not all) good monetary policymakers who were formally trained as such have an almost instinctual attachment to some of those problematic concepts and hard-toestimate variables.

To this point, ignoring for the moment the C-19 episode, my strongly held conviction is that, for almost 3 decades, the Fed never eased monetary policy. Monetary policy was either appropriate (managing a stable rate of growth for NGDP), or tight to differing degrees (in 08/09, for example, it was clearly tighter than in 02/03)! (Here I´m not considering as monetary policy easing the corrections that follow tightening mistakes).

As the charts below indicate, monetary policy tightening comes about not when the FF rate goes up, but when money supply growth (under the close control of the Fed, evidenced by the fact that NGDP growth remains stable for extended periods) fails to offset changes in velocity so as to keep NGDP growth stable.

The past 3+ years are “truly” exceptional. One dimension is purely statistical and conveyed by the much wider swings in most variables. The other is monetary in nature.

Initially, monetary policy was very tight, notwithstanding the drop in the FF rate to “zero”. The tightening was the result of the “quick & deep” drop in velocity when C-19 caught everyone by surprise. The monetary policy reaction was “quick & swift”, with money supply growth ballooning, making the recession, although deep, the shortest on record (just two months). Pictures like the ones below were already popping-up as early as April and June 2020!

In Spring 2020, some saw those money supply growth figures and quickly said “very high” inflation was on the cards. Quite the contrary, if money supply growth had continued to behave as previously, real output, instead of clocking -9% by mid-2020, would have dropped at least -20%, putting the Great Depression to shame!

In early 2021, for the first time in 30 years, monetary policy became “truly expansionary”, with the level of NGDP climbing above its trend level path. Inflation being a monetary phenomenon, reacted accordingly, and with no discernible lag at all!

Since early 2022, also for the first time in 30 years, an increase in the Fed Funds rate has been “consistent” with monetary policy tightening! My “cynic side” will conjecture that, since the steep increase in the FF rate took place in an environment of “true” monetary tightening (the left hand side of the charts below), its effect was mostly to produce a banking crisis! (In 2008, the financial crisis happened in an environment where the FF rate was dropping BUT monetary policy was EXTREMELY tight. At the present time, monetary policy is “only” being gradually tightening).

A view from the stock market

The chart below shows the behavior of the stock market (S&P 500), with the bars corresponding to periods when the FF rate was increased (I have used the logarithmic scale, so that the slope of the line at each point indicates the rate of growth of the market).

Notable, and very much consistent with the view that interest rates are a poor indicator of the stance of monetary policy, the stock market was usually rising when rates were increasing, but dropped significantly when monetary policy was effectively tightened (as indicated by the behavior of NGDP growth).

Now, interest rates have increased substantially, but the actual tightening of monetary policy is seen in the fall in NGDP growth. That is what explains the behavior of the market, not the fact that the FF rate has increased.

[Note: On the stock market-NGDP nexus, I suggest you look at Mike Sandifer´s Exact Macro Market Monitor].

For Nominal Stability to be regained, the Fed has to “calibrate” money supply growth so that, given the behavior of velocity (for the past year, velocity growth has remained quite stable, but the ongoing banking woes may change that), NGDP growth rises at a 4%-5% click. Inflation will converge to target, real growth will increase at a stable rate and unemployment will remain low. Oh!, under that scenario, there will be no complaints about the behavior of the S&P 500!