Why is monetary policy tightening but the economy continues to boom?

Author: Alp Simsek, Professor of Finance, Yale School of Management

Compiled by: Tia, Techub News

Editor 's note:

Under the current global economic situation, the Federal Reserve 's monetary policy has received unprecedented attention. The U.S. economy remains strong despite policy rates rising to historic highs, a phenomenon that appears to defy the expectations of conventional economic theory. The continued hotness of the job market and the steady growth of the economy beg the question: Why has tight monetary policy failed to curb economic overheating as effectively as in the past? The latest research points out that behind this phenomenon is not a paradox, but the limitations of traditional analytical frameworks. By revisiting the impact of financial conditions on the economy, we can gain a deeper understanding of the actual transmission mechanism of monetary policy.

The Federal Reserve has raised interest rates to historic levels, but the economy is still on the upswing. The current strong jobs report is proof of that. Why does this happen?

According to our latest paper, maybe it's because we're focusing on the wrong metrics.

While policy rates are high, financial conditions are actually quite accommodative. Rising stocks and tighter credit spreads effectively offset much of the Fed's tightening.

Data show that the FCI-G index designed by the Federal Reserve itself (an index that combines financial variables to measure their impact on economic growth) confirms this. While long-term interest rates are rising and the U.S. dollar is strengthening, positive market performance, primarily a boom in equity markets and improving credit spreads, is stimulating economic growth.

Tight monetary policy and strong growth are not actually a paradox.

In our research with Ricardo Caballero and @TCaravello we show that what matters to the economy is not the policy rate itself, but broader financial conditions.

Our analysis shows that when financial conditions ease, even when driven by noisy asset demand (sentiment), it stimulates output and inflation, ultimately forcing interest rates higher. This is consistent with what we are seeing today.

From a quantitative perspective, the study found that financial conditions account for as much as 55% of the impact of economic output fluctuations.

In addition, the main transmission method of monetary policy should be to affect financial conditions rather than directly through interest rates.

The current situation fits this framework: despite higher interest rates, easy financial conditions are supporting strong growth and may prevent inflation from returning to target.

Looking ahead, this suggests the Fed's work is not done yet. To achieve the 2% target, financial conditions may need to tighten.

This could happen through: a market correction - a stronger dollar - further interest rate hikes.

The path of interest rates will largely depend on market dynamics. If markets correct and the dollar strengthens, current interest rate levels may be sufficient. But if financial conditions remain accommodative, further interest rate increases may be needed.

This framework suggests that Fed watchers should focus less on the "terminal rate" debate and more on the evolution of financial conditions. This is where the real monetary policy transmission occurs.

While our paper goes one step further by proposing clear FCI targets, more importantly we need to change the way we think and talk about monetary policy. The policy rate is only one input, financial conditions are what really matters.