Why does the economy continue to boom despite tight monetary policy?

Written by: Alp Simsek, Professor of Finance, Yale School of Management; Translated by: Tia, Techub News

Editor's Note:

In the current global economic situation, the Federal Reserve's monetary policy has received unprecedented attention. Despite the policy interest rate has risen to a historical high, the US economy remains strong, a phenomenon that seems to go against the expectations of traditional economic theory. The continued hot job market and steady economic growth make people wonder: Why has the tight monetary policy not been as effective as in the past to curb the overheating of the economy? The latest research points out that the reason behind this phenomenon is not a paradox, but the limitations of the traditional analytical framework. By re-examining the impact of financial conditions on the economy, we can better understand the actual transmission mechanism of monetary policy. 

The Federal Reserve has raised interest rates to historical levels, but the economy is still on the rise. The current strong employment report is proof of this. Why is this the case?

According to our latest paper, perhaps it is because we are focusing on the wrong indicators.

Although the policy interest rate is high, the financial environment is actually quite loose. Rising stock markets and tighter credit spreads have effectively offset much of the Fed’s tightening. The data shows that the Fed’s own FCI-G index (an index that aggregates financial variables to measure their impact on economic growth) confirms this. While long-term interest rates are rising and the dollar is strong, the positive performance of markets (mainly the stock market boom and improved 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 it is not the policy rate itself that matters for the economy, but rather the broader financial conditions. Our analysis shows that when financial conditions are loose, even if driven by noisy asset demand (sentiment), they stimulate output and inflation, eventually forcing interest rates higher. This is consistent with what we are seeing today. From a quantitative perspective, the research finds that financial conditions account for up to 55% of the volatility of economic output.

Moreover, the primary transmission of monetary policy should be through its impact on financial conditions, rather than directly through interest rates.

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

Looking ahead, this suggests that the Fed’s mission is not yet complete. To achieve its 2% target, financial conditions may need to tighten.

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

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

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

While our paper goes a step further and proposes an explicit FCI target, more importantly, we need to change the way we think and talk about monetary policy. The policy rate is just an input; financial conditions are what really matter.