Is money getting tighter?
Probably, but not tight enough.
In recent months, I’ve expressed skepticism about the claim that the Fed has been tightening monetary policy since last fall, via forward guidance. In my view, most of the increase in interest rates over the past year is due to the Fisher (expected inflation) effect, not the liquidity effect of tight money.
But in the past few weeks there is some evidence that monetary tightening might be beginning to take hold. Consider:
1. Five-year TIPS spreads peaked at 3.59% on March 25th, and have since fallen to 2.88%.
2. Ten year bond yields peaked at 3.12% on May 6th, and are down to 2.78%.
3. Stocks have fallen sharply in recent weeks.
4. The dollar has appreciated significantly in recent weeks.
I define a contractionary monetary policy as a policy stance that slows expected nominal GDP growth. We don’t have a perfect measure of market expectations for NGDP, but each of the four data points above provide some indication of where things might be headed.
1. TIPS spreads are correlated with market forecasts of inflation. Unfortunately, inflation and NGDP don’t always move in the same direction, due to supply shocks.
2. Nominal bond yields are the sum of expected inflation and real interest rates. Because real interest rates are somewhat correlated with real GDP growth, longer-term bond yields are correlated with expected NGDP growth. Lower bond yields usually imply lower expected NGDP growth. Unfortunately, a tight money policy can sometimes boost long-term bond yields in the short run, due to the liquidity effect.
3. Stocks are somewhat correlated with expected real GDP growth. Unfortunately, the stock market is noisy, and hence stock movements should be interpreted with caution.
4. A tight money policy tends to appreciate a currency, although currencies move around for other reasons as well.
Thus all 4 indicators that I cited are somewhat imperfect. Nonetheless, all four have recently been moving in a direction consistent with tighter money, which is a pretty strong indication that monetary policy has been getting at least a bit tighter.
Even so, policy is still too
tight loose, at least relative to the Fed’s 2% average inflation target.
PS. This Bloomberg piece caught my eye:
After a violent rally in bonds, Treasury traders are debating whether recent tough talk from the Federal Reserve on its commitment to cooling prices is enough to reverse the trend.
I wonder if the opposite isn’t true. Perhaps it’s the recent tough talk from the Fed that is driving down bond yields and driving up bond prices.
PPS. What about a recession this year? No one is able to predict recessions. Right now, markets seem to be predicting continued economic growth, slowing over time. But that forecast could change quite rapidly.