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When the Federal Reserve raised interest rates between mid-2004 and mid-2006, Federal Reserve Chairman Alan Greenspan often lamented the conundrum he and other policymakers faced. The problem was that no matter how many times the Fed hiked rates (a total of 17 times, to be precise), financial conditions would ease, mostly in the form of lower long-term bond yields.
What central bankers didn’t seem to understand was that this was all a classic case of misinformation. The Fed believed that easier financial conditions indicated that markets did not believe in its determination to contain inflation, when in fact it was the opposite. Markets pushed long-term bond yields down and stocks higher on belief that the Fed was getting inflation under control.
We could see history repeating itself, increasing the likelihood that the central bank will tighten monetary policy too much and cause undue damage to the economy. In the minutes of the Federal Open Market Committee’s May 13-14 meeting, released Wednesday. On December 30, the easing of financing conditions has been discussed since early November. This was clearly of concern as members called the development “unjustified”:
Participants noted that unwarranted loosening of financial conditions, particularly if caused by a misperception of the public’s perception of the Committee’s responsiveness role, would complicate the Committee’s efforts to restore price stability, given that monetary policy operates largely through financial markets .
In addition, policymakers seemed to link the easing of funding conditions to a “misperception” of their responsiveness function. Recall that at the time of the meeting there was much talk of the possibility of the Fed ‘turning’ from its hawkish stance as there were signs that inflationary pressures were beginning to ease. The “Pivot” never had much of a chance. The minutes show that the Fed took such talks seriously and was quick to put an end to such speculation.
But that ignores the burgeoning signs of disinflation we are seeing in the economy. Oil and gas prices have fallen, which has helped lower overall commodity costs. Apartment rents have slowed significantly and used car prices have collapsed. Supply chains are opening up further, allowing goods to flow more freely through the economy. On Wednesday, the Institute for Supply Management said the proportion of prices paid in its manufacturing index fell for the ninth straight month.
There is another explanation to consider, and that is that the easing in financial conditions, led by lower long-term bond yields and a weakening dollar, is a reflection of the market saying the Fed is going too far and inevitably pushing the economy into crisis becomes recession. The transcript indicated that even some Fed officials brought up this thought:
Participants noted that financial conditions have eased since the November meeting, with the market implied path for the federal funds rate beyond 2023 and longer-term yields declining notably. Some participants noted that the current configuration of nominal yields, with longer-term yields being lower than shorter-term yields, has historically preceded recessions and should therefore be monitored. However, some of them also pointed out that the current yield curve inversion may partly reflect that investors expect the nominal policy rate to fall due to falling inflation over time.
A recession is always possible, but most economists have it in 2024, giving plenty of time to avoid one. In my opinion, it’s the last word on “a fall in inflation” that probably best explains the easing of financial conditions, which policymakers should be cheering for rather than fret about at this point. More from the Bloomberg Opinion:
• Do you want trading success? Learn Poker, Not Economics: Aaron Brown
• What could go wrong for the Federal Reserve in 2023: Bill Dudley
• The market is ready to move on. Fed is clearly not: Jonathan Levin
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Robert Burgess is Editor-in-Chief of Bloomberg Opinion. Previously, he was Global Editor-in-Chief for Financial Markets at Bloomberg News.
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