Though we have had a year of increases in the U.S. Fed’s policy rate, by other measures conditions haven’t tightened very much. The real Fed Funds rate remains negative and a broad measure of financial conditions shows recent loosening.

In Focus - Loose Money

How tight is U.S. monetary policy in actuality? It feels as though it’s tight; everyone seems to think it is. And we are now fast approaching the one year anniversary of the Federal Reserve’s hawkish phase. In the interim, the target rate went from roughly zero to about 4.5%, the most dramatic increase we have seen since the Volcker years in the late 70s / early 80s.

Yet the labor market remains tight, consumption steady, and inflation measures are well-above the Fed’s target. If the monetary brakes are indeed being slammed, why isn’t the economy responding in kind?

There are several possible answers. First, economists generally expect the effects of monetary policy to appear with “long and variable lags.” Atlanta Fed President Raphael Bostic translated that into meaning 18-24 months, if not longer. So one answer is: Give it time. We will see it. Eventually.

Two other potential answers are depicted in the graph. The red line (right hand scale) is an alternative view of the Fed Funds rate, subtracting a conservative measure of inflation (Trimmed Mean PCE). The result is a real Fed Funds rate, usually more relevant for economic decisions.

The real Fed Funds rate, as calculated here (and using an estimate for February inflation), is about to touch zero for the first time since September 2019. For context, the most recent, inflation-fighting period was the late 1970s.

The key finding here then is that negative real interest rates are rare, even in inflation-fighting times. For twenty-three years, from the start of 1978 to the end of 2000, the Fed Funds rate was below PCE inflation for just three months. Those months were in the summer of 1980, when inflation receded slightly and the Fed instituted a dramatic rate cut, only to have to raise rates to new highs by the end of the year.

The last measure is the Chicago Fed’s National Financial Conditions Index (NFCI, green line, left hand scale). Whereas the Fed Funds rate is a very short-term rate, much economic activity is driven by longer rates, such as those on mortgages. The NFCI captures a broad range of measures and is calibrated so that results above zero reflect tight financial conditions, below reflect loose.

By this measure, conditions have not been tight since the onset of the pandemic.

After a rise toward neutrality in 2022, the NFCI loosened from October. As of late February this year, 11 measures were tighter than average, and 94 looser than average. How could this be? If capital markets don’t believe that the Fed will keep rates high for long, mortgage and other longer-term rates may fall.

How tight is money? By these measures, not very. If one thinks that hawkish monetary policy is required to tame inflation, then the implication is that we’re nowhere near the end of the current cycle. Work remains. Work that will weigh on economic activity.

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Economic Developments

U.S. non-farm productivity rose by 1.7% in Q4 2022, a cheering release, albeit one diminished by the fact that the figure came in well below the initial estimate of +3.0% and that, on an annual basis, the annual decline of -1.7% was the largest decline in almost fifty years.

China’s latest Purchasing Managers Index spiked to a 10-year high in February, coming in at a reading of 52.6 (any figure above 50 indicates an expansion). This is one indication that the Chinese economy is working back to normalcy.

Japan retail sales were up 1.9% year-on-year on a seasonally-adjusted basis in January (6.3% from December, unadjusted). It was the eleventh straight month of increasing sales, somewhat counterintuitive for a consumer market many consider moribund. This beat forecasts yet again, which were predicting a far lesser rise.

Euro area headline inflation was around 8.5% in February, according to a preliminary estimate. Core inflation, stripped of energy and prices, rose from 5.3% to 5.6%. However, the core Euro area, including Germany, France and Italy, continues to experience less price volatility than the periphery, where inflation is registering 15-20% monthly, as in Latvia and Slovakia.

In an optimism-tempering development, the WTO’s latest Goods Trade Barometer, a lagging indicator for global trade, intended as a composite leading indicator, came in well below trend for Q4 2022, which creates some dissonance with the organization’s most recent forecast update that concluded trade in merchandise was likely stronger than expected last year.

Despite a policy of trade barriers explicitly targeting trade imbalances, new research shows that the U.S. deficit in trade in manufactured goods has doubled since 2016, rising to $1.2 trillion in 2022 in nominal terms from $650 billion.

Political Developments

Former President Trump, now on the campaign trail, laid out a China trade policy in a recent speech that stakes out increased barriers to trade as a major part of his platform.

The long-simmering question of Brexit, Northern Ireland and the EU is somewhat closer to a resolution, following the announcement last week of The Windsor Framework, a negotiated settlement that, in principle, will allow for more trade to freely flow across borders once again. As always, though, the devil is in the passage and implementation.

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