What the Federal Funds Rate Isn’t Telling You

Lately, Federal Reserve officials have been paying greater attention to financial conditions – that is, to the influence that market phenomena such as stock prices, bond yields and housing prices have on economic activity, above and beyond the effect of the short-term interest rates that the central bank controls directly.

This is a welcome development for monetary policy — and for me personally.

Nearly 25 years ago, when I was chief US economist at Goldman Sachs, my colleague Jan Hatzius and I created a financial conditions index as a tool for assessing the economic outlook and the appropriateness of the Fed’s monetary policy stance. While its construction has evolved considerably since then, the conceptual framework remains intact. Over the years, many others developed comparable indexes. This summer, the Fed introduced a new one of its own.

Such indicators are crucial, because monetary policy does not operate exclusively through short-term interest rates, particularly in the US. A lot of financial intermediation happens outside the traditional banking system. Home purchases are financed mainly by long-term fixed-rate mortgages that are packaged into securities and sold to investors. Companies raise money in capital markets, too. So various market prices, from risky companies’ cost of borrowing to the dollar’s exchange rate, matter for the economic outlook.

Financial conditions wouldn’t merit much attention on their own if they always moved in lockstep with the Fed’s short-term interest-rate target. They don’t. The stock market can rally or fall independent of short-term rates. The dollar’s value can change depending on economic activity abroad and how that affects monetary policy elsewhere. Distress in the banking system can tighten financial conditions independently, as happened when a group of regional US lenders ran into trouble this spring.

In the US, the linkage between financial conditions and short-term interest rates was tight through the 1970s and early 1980s, in part because of the way the monetary policy was implemented. Prior to 1994, the Fed didn’t even announce interest-rate changes. Market participants inferred what had happened from the central bank’s open market operations and how this affected the level of the federal funds rate.