The Fed has a Greenspan conundrum on its hands

Federal Reserve Board Chairman Jerome Powell during a news conference in Washington, DC. The Federal Reserve announced that it will raise interest rates by a 0.5 percentage point to 4.5. (Photo by Alex Wong/Getty Images)

When the Federal Reserve was raising interest rates between mid-2004 and mid-2006, then central bank Chairman Alan Greenspan would often lament the conundrum he and fellow policymakers faced. The issue was that no matter how many times the Fed boosted rates (a total of 17 times, to be exact), financial conditions would ease, mainly in the form of lower long-term bond yields.

What central bankers didn’t seem to understand was that it was all a classic case of misinformation. The Fed thought easier financial conditions suggested that markets didn’t believe its resolve to rein in inflation, when it was really the opposite. Markets were beating down long-term bond yields and bidding up stocks because it believed the Fed would get inflation under control.

We may be seeing history repeat itself, raising the odds that the central bank tightens monetary policy too much, causing undue damage to the economy. In the minutes of the Federal Open Market Committee’s December 13-14 meeting released on Wednesday, there was a discussion about the easing of financial conditions since the beginning of November. This was clearly worrisome, with members describing the development as “unwarranted”:

Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee’s reaction function, would complicate the committee’s effort to restore price stability.

Furthermore, policymakers seemed to tie the easing of financial conditions to a “misperception” of its reaction function. Recall that at the time of the meeting, there was lots of talk about the possibility of a Fed “pivot” away from its hawkishness given budding signs that inflationary pressures were starting to ease. The “pivot” never had much of a chance. The minutes show the Fed took such talk seriously and quickly wanted to put an end to such speculation.

But that ignores the budding signs of disinflation we’re seeing in the economy. Oil and gas prices have tumbled, helping to reduce the cost of commodities overall. Apartment rent gains have slowed considerably and used-car prices have plunged. Supply chains continue to open up, allowing for goods to flow more freely through the economy. On Wednesday, the Institute for Supply Management said the prices paid portion of its manufacturing index declined for the ninth straight month.

There is another explanation to consider, which is that the easing of financial conditions, led by lower long-term bond yields and a depreciating dollar, is a reflection of the market saying the Fed is going too far and will inevitably push the economy into a recession. The minutes pointed out that even some Fed officials raised that notion:

Participants noted that since the November meeting, financial conditions had eased, with the market-implied path for the federal funds rate beyond 2023 and longer-term yields coming down noticeably. A few participants remarked that the current configuration of nominal yields, with longer-term yields lower than shorter-term yields, had historically preceded recessions and hence bore watching. However, a couple of them also noted that the current inversion of the yield curve could reflect, in part, that investors expect the nominal policy rate to decline because of a fall in inflation over time.

A recession is always a possibility, but most economists have that pencilled in for 2024, leaving plenty of time to avoid one. For my money, it’s that last bit about “a fall in inflation” that probably best explains the easing financial conditions, which policymakers should cheer rather than fret about at this point.  

Robert Burgess is the executive editor of Bloomberg Opinion. Views are personal and do not represent the stand of this publication.

Credit: Bloomberg