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FRBSF Economic Letter 2023-03 | February 6, 2023 Research from the Federal Reserve Bank of San Francisco Financial Market Conditions during Monetary Tightening Simon H. Kwan and Louis Liu The current round of federal funds rate increases is expected to reverse a historically large gap between the real funds rate and the neutral rate at the beginning of the tightening cycle. Financial markets have reacted faster and more strongly than in past monetary tightening cycles, in part because of this large gap and the Federal Reserve’s forward guidance. Historical experiences suggest financial conditions could tighten even more given the size of the gap. Financial markets play a central role in how business cycles fluctuate and spread through the U.S. economy. As monetary policy works through various transmission channels to impact real economic activity, financial market channels are first and foremost in determining both the speed and the extent of policy transmission (Bernanke, Gertler, and Gilchrist 1999). Thus, understanding how much financial conditions have tightened provides important feedback for calibrating monetary policy. In past monetary tightening episodes, the degree of tightening in overall financial conditions depended on how much and how long monetary tightening continued, as well as prevailing economic conditions when tightening began. Specifically, the extent of monetary tightening depends on inflationary pressures and how strong the economy is when tightening starts. In past cycles, federal funds rate increases ranged from about 1 percentage point (1965–66) to over 10 percentage points (1977–80). This Economic Letter compares the size and the speed of financial market responses between current and past cycles of monetary tightening. We focus on analyzing long-term interest rates, stock prices, and credit spreads because they directly affect the cost of capital and thus real economic activity. Since the current tightening cycle is likely still ongoing, the financial market response could still change substantially. Nevertheless, comparing current financial market changes to those during previous tightening cycles sheds light on the speed of adjustment. Monetary tightening cycles Figure 1 shows the 15 postwar monetary tightening cycles. The first 11 cycles are identified following the methodology in Adrian and Estrella (2008). This assumes that a tightening cycle starts when the federal funds rate rises by 0.25 percentage point (25 basis points) or more in two consecutive months. A tightening cycle ends when either (1) the federal funds rate is higher than at any time from 12 months before to 9 FRBSF Economic Letter 2023-03 | February 6, 2023 months after and is at least 0.5 percentage point higher than at the beginning of this period, or (2) the federal funds rate is higher than at any time from 6 months before to 6 months after and is 1.5 percentage points higher than the average at these end points. Figure 1 Effective federal funds rate Percent 20 18 16 14 12 Since the late 1990s, forward guidance 10 became a prominent monetary policy 8 tool (Bernanke 2020). We therefore 6 identify the tightening cycles based on 4 the Federal Open Market Committee 2 (FOMC) communications, as financial 0 markets are always forward looking. For 1974 1984 1994 2004 2014 1954 1964 example, forward-looking language first Source: Federal Reserve Board of Governors and authors’ calculations. Note: Blue shading indicates periods of monetary policy tightening as described in text. appeared in the post-meeting FOMC press release in May 1999. Although the Committee decided not to raise rates at that meeting, the postmeeting press release signaled the FOMC’s bias toward the possibility of a firming in the stance of monetary policy. We therefore assume the 1999-2000 tightening cycle started in May, even though the policy rate did not increase until June. For the current tightening cycle, the Committee expected after its January 2022 meeting that “it will soon be appropriate to raise the target range for the federal funds rate.” In the December 2022 FOMC Summary of Economic Projections (SEP), the median projection of the federal funds rate for 2023 by FOMC participants was 5.1%, compared to 4.4% for 2022. In this Letter, we make the straightforward assumption that the federal funds rate will reach 5.1% about the middle of this year, based on the contour of the federal funds futures. Hence, the current tightening cycle is assumed to last from January 2022 to May 2023, lifting the federal funds rate from 0.08% to 5.1%. The federal funds rate Each tightening cycle has been unique in terms of the duration and the change in the federal funds rate. Not all tightening cycles have been followed by recessions. The median increase in the federal funds rate in past tightening cycles was 2.57 percentage points, and the median pace of tightening was 0.20 percentage point per month. For the current cycle, based on the SEP projections, the expected tightening is 5.02 percentage points at an average pace of 0.31 percentage point per month, both of which are well above the median. To control for monetary conditions at the onset of tightening, we compute the real funds rate gap by subtracting the inflation rate and the real neutral rate from the nominal federal funds rate. The smaller or more negative the real funds rate gap is, the more monetary accommodation is in the economy. We use the past 12-month change in the consumer price index (CPI) to measure the inflation rate. Although current CPI 2 FRBSF Economic Letter 2023-03 | February 6, 2023 inflation is an imperfect proxy for expected inflation, the Survey of Professional Forecasters’ expected oneyear-ahead inflation rate, which did not start until 1980, provides qualitatively similar results for the last six tightening cycles. We use the real neutral rate estimated by Laubach and Williams (2003). For the current cycle, we use a real neutral rate of 0.5%, Figure 2 which is the difference between the Real funds rate gap: Initial levels and changes over cycle median long-run funds rate of 2.5% from Percentage points the December SEP and the 2% target 10 inflation rate. Start of cycle Change over cycle 5 Figure 2 shows the real funds rate gap (blue bars) at the beginning of each 0 tightening cycle. The real funds rate gap of –7.9% at the beginning of the current cycle is the largest among all tightening -5 cycles, in part due to high inflation. Figure 2 also shows the difference in the -10 Dec Dec Apr Feb Mar Apr Feb Jul Mar Feb May May Dec Jan real funds rate gap between the end and 1965 1968 1971 1972 1974 1977 1981 1983 1988 1994 1999 2004 2016 2022 the beginning of each tightening cycle— -Nov -Aug -Aug -Sep -Jul -Apr -Jun -Aug -Mar -Apr -Jul -Jul -Feb -May which reflects how much the gap was 1966 1969 1971 1973 1974 1980 1981 1984 1989 1995 2000 2006 2019 2023 Source: Laubach and Williams (2003), Bureau of Labor Statistics, Federal Reserve Board closed (green bars). Assuming the of Governors and authors’ calculations. inflation rate at the end of the current Note: Last cycle includes assumptions based on December 2022 SEP projections. tightening cycle will be 3.1% based on the December SEP, the real funds rate gap at the end of the current cycle would be 1.5%. If the Fed successfully closes the funds rate gap by 9.4% by the end of the current cycle—through both raising the interest rate and bringing down inflation—it would be the largest gap closure on record. Long-term rates and stock prices The current increase in the 10-year Treasury rate is the second largest increase of all tightening cycles, shown by the blue bars in Figure 3. Moreover, the green bars show that the speed of this increase has been unprecedented. Research shows that the response of asset prices to anticipated monetary policy changes is essentially zero, while their response to unanticipated movements is large and highly significant (Kuttner 2000). Thus, before forward guidance, each monetary policy tightening may have contained unanticipated information that had not been fully incorporated into asset prices; therefore, without advance communication, financial markets would have reacted to each tightening until the cycle ended. With forward guidance, market participants can form expectations about tightening cycles, including the expected duration and amount of tightening. Because the expected tightening is fully incorporated into asset prices well before the completion of the tightening cycle, this partially explains the speed of the increase in long-term rates in the current cycle. 3 FRBSF Economic Letter 2023-03 | February 6, 2023 A widely held view by economists is that long-term interest rates tend to have relatively bigger effects on real economic activities than short-term rates. This is in part due to the large share of long-term debt contracts with a fixed interest rate in our financial system, including fixedrate mortgages, term loans, and corporate bonds, whose rates are often tied to long-term Treasury rates. Thus, the rapid increase in long-term rates would cool the economy relatively faster than in previous cycles. The contract interest rate above the Treasury rate, known as the spread, is another determinant of financial conditions. The spread reflects the risk premium demanded by the lender in providing debt financing to risky borrowers. In past tightening cycles, bond spreads haven’t always tightened, and the median change in the benchmark Baa bond spread was close to zero. Currently, the Baa spread has widened only about 0.06 percentage point, which is small relative to the large increase in the long-term Treasury rate. Figure 3 Percentage point changes in 10-year Treasury yield Percentage point 0.8 Percentage points 3.5 Total change (left scale) 3 Average monthly change (right scale) 2.5 Median total change = 0.48 percentage point 0.6 2 0.4 1.5 1 0.2 0.5 0 Dec Dec 1965 1968 -Nov -Aug 1966 1969 Apr 1971 -Aug 1971 Feb 1972 -Sep 1973 Mar 1974 -Jul 1974 Apr 1977 -Apr 1980 Feb 1981 -Jun 1981 Jul 1983 -Aug 1984 Mar 1988 -Mar 1989 Feb 1994 -Apr 1995 May 1999 -Jul 2000 May 2004 -Jul 2006 Dec 2016 -Feb 2019 0 Jan 2022 -Dec 2022 Source: Federal Reserve Board of Governors and authors’ calculations. Figure 4 Percent changes in Standard & Poor’s 500 Percent Percent 25 20 15 Total change (left scale) Average monthly change (right scale) Median % change = 2.53% 4 3 10 2 5 1 0 0 -5 -1 -10 -2 -15 -3 In previous tightening episodes, stock -20 Sep Aug Dec Dec Apr Feb Mar Apr Feb Jul Mar Feb May May Dec Jan prices initially fell but sometimes 1955 1958 1965 1968 1971 1972 1974 1977 1981 1983 1988 1994 1999 2004 2016 2022 -Oct -Nov -Nov -Aug -Aug -Sep -Jul -Apr -Jun -Aug -Mar -Apr -Jul -Jul -Feb -Dec rebounded to end the tightening cycle 1956 1959 1966 1969 1971 1973 1974 1980 1981 1984 1989 1995 2000 2006 2019 2022 with a net gain. Figure 4 shows that stock Source: Bloomberg, Federal Reserve Board of Governors and authors’ calculations. prices declined on net in five of the past 15 tightening episodes. The median change in the Standard & Poor’s 500 in previous cycles was +2.53%. Both the current decline in stock prices and the speed of the decline, as measured by the average monthly change in stock prices, are large relative to the historical average. Stock valuations, such as the price-toearnings ratio, exhibit similar patterns. Comparing the current changes in bond rates and stock prices to those in previous completed tightening cycles that lasted longer reflects the notion that forward guidance has front-loaded the financial market 4 5 -4 FRBSF Economic Letter 2023-03 | February 6, 2023 response in the current cycle. This is consistent with the stance of monetary policy being tighter than what is implied by the federal funds rate (Choi et al. 2022). Repeating the analysis to control for cycle duration yields qualitatively similar results. Insights from the past What can we learn from history to understand how financial conditions could play out through the end of this tightening cycle? The historical relation between monetary conditions at the onset of tightening cycles and tightening in interest rates and stock prices may provide some clues. Regressing the real funds rate gap on the change in the federal funds rate yields a significantly negative relationship: a more negative real funds rate gap tends to be followed by a bigger increase in the federal funds rate. Given the large negative real funds rate gap in the current cycle, history suggests that the total increase in the federal funds rate could be bigger than expected. Regressing the real funds rate gap on the change in stock prices yields a significantly positive relationship, implying that the more negative the real funds rate gap, the larger the decline in stock prices during a tightening cycle. When we use this historical relationship to evaluate stock prices at the large negative funds rate gap, stock prices are projected to decline further. The historical relationship between the funds rate gap and bond spreads also calls for more tightening in the bond market. Taken together, with the historically large funds rate gap at the onset of the current cycle, past experiences indicate that more tightening of financial conditions could follow. Conclusions Current increases in the federal funds rate are expected to reverse a historically large negative real funds rate gap at the beginning of the cycle. Successfully closing the real funds rate gap will hinge on substantially reducing the inflation rate. Relative to history, both the size and the speed of tightening in Treasury bonds and common stocks have been large in the current cycle, in part because of the large gap and the Federal Reserve’s forward guidance. While the rapid tightening of financial conditions is expected to slow the economy relatively quickly, historical experiences raise the possibility of even more tightening in financial conditions given the large real rate gap that needs to be closed. Simon H. Kwan Senior Research Advisor, Economic Research Department, Federal Reserve Bank of San Francisco Louis Liu Research Associate, Economic Research Department, Federal Reserve Bank of San Francisco References Adrian, Tobias, and Arturo Estrella. 2008. “Monetary Tightening Cycles and the Predictability of Economic Activity.” Economics Letters 99(2), pp. 260–264. Bernanke, Ben S. 2020. “The New Tools of Monetary Policy.” American Economic Review 110(4, April), pp. 943–983. 5 FRBSF Economic Letter 2023-03 | February 6, 2023 Bernanke, Ben S., Mark Gertler, and Simon Gilchrist. 1999. “The Financial Accelerator in a Quantitative Business Cycle Framework.” Chapter 21 in Handbook of Macroeconomics 1, part C, eds. J.B. Taylor and M. Woodford. Amsterdam: Elsevier, pp. 1,341–1,393. Choi, Jason, Taeyoung Doh, Andrew Foerster, and Zinnia Martinez. 2022. “Monetary Policy Stance Is Tighter than Federal Funds Rate.” FRBSF Economic Letter 2022-30 (November 7). Kuttner, Kenneth N. 2001. “Monetary Policy Surprises and Interest Rates: Evidence from the Fed Funds Futures Market.” Journal of Monetary Economics 47(3, June), pp. 523–544. Laubach, Thomas, and John C. Williams. 2003. “Measuring the Natural Rate of Interest.” Review of Economics and Statistics 85(4, November), pp. 1,063–1,070. Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Anita Todd and Karen Barnes. Permission to reprint portions of articles or whole articles must be obtained in writing. 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