A few years ago, I criticized the view that rising long-term interest rates represented a tightening of monetary policy. This was in response to Fed claims that even though they had not yet begun to raise their short-term policy rate, rising bond yields effectively tightened policy. I think we now know that the Fed’s theory was wrong, as inflation and NGDP rose very sharply in 2022. Policy was highly expansionary at that time and yields rose due to rapid NGDP growth.
At today’s Fed press conference, Nick Timiraos asked a very good question:
Q: Nick Timiraos of The Wall Street Journal. Chair Powell, you’ve argued over the last year that policy tightening started before you actually lifted off because the market anticipated your moves and tightened on your behalf. The market is now easing policy on your behalf by anticipating a funds rate by next September that’s a full point below the current level, with cuts beginning around March. Is this something that you are broadly comfortable with?
MR. POWELL: So this last year has been remarkable for the sort of seesaw thing back and forth we’ve had over the course of the year of markets moving away and moving back and that kind of thing. So—and what I would just say is that we focus on what we have to do and how we need to use our tools to achieve our goals, and that’s what we really focus on. And people are going to have different forecasts about the economy, and they’re going to—those are going to show up in market conditions or they won’t. You know, but in any case, we have to do what we think is right.
And, you know, in the long run—it’s important that financial conditions become aligned or are aligned with what we’re trying to accomplish. And in the long run they will be, of course, because we will do what it takes to get to our goals. And ultimately that will mean that financial conditions will come along. But in the meantime, there can be back and forth. And, you know, I’m just focused on what’s the right thing for us to do. And my colleagues are focused on that too.
In general, Jay Powell gave very cogent answers at today’s press conference. He seemed fairly confident that the Fed was well on its way to bringing inflation back to 2% without a major recession. But the answer to Timiraos’s question is obviously pretty weak. If the rising market rates of late 2021 really did indicate policy tightening, then the sharply falling rates of the past 6 weeks would indicate substantial easing. But elsewhere Powell insists that it’s too soon to ease policy, as we need clearer evidence that inflation is on track to fall back to 2%. You can’t have it both ways.
In fact, Powell was wrong to be reassured by rising bond yields back in late 2021, and he’s right not to be concerned by sharply falling bond yields in recent weeks. I hope the Fed never again relies on the faulty theory that movements in long-term rates are evidence of a change in monetary policy—they often reflect changes in expectations about the future path of NGDP growth.
READER COMMENTS
Lizard Man
Dec 13 2023 at 9:41pm
Should the Fed have reasoned that a rise in long term interest rates indicated that their policy had become more loose, because rates would only rise if expectations for NGDP growth had gone up? Likewise, should the Fed be taking falling interest rates as evidence that their policy has become tighter?
Thomas L Hutcheson
Dec 13 2023 at 9:59pm
Powell did not say that changes in LT rates are evidence of a change in policy. They could be evidence of market speculation about a future change in monetary policy instruments settings or about a change in how the market thinks that current instrument settings will affect the economy. The latter could be useful information to the Fed in updating its own model of how instrument settings affectt he economy.
I thought he was pretty clear, the Fed sets its instruments at levels it thinks will achieve its targets and markets speculate about how successful those levels and expected future levels will be.
Scott Sumner
Dec 14 2023 at 12:44pm
“Powell did not say that changes in LT rates are evidence of a change in policy.”
Yes, he did.
mira
Dec 14 2023 at 10:09am
If anything, the long-term rates should be taken almost the opposite way.
Short-term rates have also been decreasing recently though – which does represent an effective loosening of policy.
Scott Sumner
Dec 14 2023 at 12:45pm
Everyone. I agree that rising long-term rates usually indicate an easing of policy, but the relationship is not certain enough to be reliable.
Thomas L Hutcheson
Dec 14 2023 at 11:21pm
In this context, what it “policy?” It it the target or the values of the policy instruments or what?
Scott Sumner
Dec 15 2023 at 12:37pm
Expected NGDP growth.
Billy Kaubashine
Dec 14 2023 at 4:12pm
It seems to me that the level of rates is only 1/2 of the equation.
What about the size of the Fed’s balance sheet? QT seems to be progressing at a very slow pace, and unless we experience an unusually long period of growth without financial crisis, the balance sheet is unlikely to ever return to pre-crisis levels.
Any thoughts??
Scott Sumner
Dec 15 2023 at 12:38pm
Unfortunately, you are probably correct. I prefer the pre-2008 system.
MarkLouis
Dec 15 2023 at 7:18am
It’s yet another pro-inflation asymmetry the Fed is seemingly unaware exists. Rising long rates represents tightening yet the opposite does not hold true. Regardless of whether either is true, it illustrates the lazy thinking underpinning these asymmetries. Feels like a dangerous backdrop when inflation is well above target and deficits are projected to increase rapidly.
MarkLouis
Dec 15 2023 at 9:12am
From Nick Timiraos this morning on X:
When asked whether financial conditions are easing in a counterproductive fashion, Williams observes that financial conditions tightened a lot from August to October. “Monetary policy is working as intended.”
What good comes from blatantly dodging important questions?
spencer
Dec 15 2023 at 9:16am
I don’t know about the current cycle. There are other compounding disturbances, e.g., movement of funds from bank accounts to MMMFs (increasing the supply of loanable funds), and the ratio of transaction accounts to gated deposits (increasing AD).
A good example of long-term interest rates rising while monetary policy wasn’t tightening was during Greenspan’s tenure, the 2002-2006 period. (i.e., despite 14 raises in the FFR (June 30, 2004, until January 31, 2006), – every single rate hike was “behind the inflationary curve”.
Michael Sandifer
Dec 15 2023 at 11:17am
Yes, it’s better to say that rising rates in the context mentioned here indicate that the Treasury market expects the Fed to begin to try to address inflation, but it certainly doesn’t mean markets expect policy to necessarily tighten. The long-term nominal rate alone doesn’t give us the market estimate of the neutral rate.
Theoretically at least, the inflation breakevens and inflation swaps should give us much more information in this regard, though the former can be unreliable during acute crises. Treasury markets can freeze up, due to poor government design.
I think the Fed should be embarrased when their forecasts differ from market forecasts and should take their lead from markets, a la the author here. If they see the inflation breakevens below target and falling, nominal yields. stock prices, and commodity prices falling, it likely indicates a negative nominal shock. They should then at least adjust forward guidance.
spencer
Dec 16 2023 at 6:46am
re: ” I think we now know that the Fed’s theory was wrong, as inflation and NGDP rose very sharply in 2022.”
—
Rates rose as the composition of the money stock changed. The ratio of transaction accounts to gated deposits steadily increased. So, AD rose.
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