What Constitutes Tight Financial Conditions? Using Interest Rates Alone Is No Longer Relevant
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The Fed raised official rates by 500 basis points from 2022 to 2023, the most significant increase over forty years, and there was no recession. The Treasury yield curve inverted for almost two years, and there was no recession. Is it time to rethink what constitutes tight financial conditions? Merely measuring financial conditions based on interest rate levels is insufficient nowadays when monetary and fiscal policies add trillions to the economy via asset purchases and budget deficits.
The traditional perspective on stringent financial conditions involves official rates higher than reported inflation, an economy expanding below its capacity, an unemployment rate significantly exceeding estimated full employment, and stagnant real and financial asset values, with the possibility of notable declines in either or both.
Yet today's economic and financial picture is the exact opposite—the economy is growing above trend, the unemployment rate is close to the full employment mark, and asset prices are at record levels.
Given these economic and financial outcomes, it becomes clear that a reassessment of our monetary and fiscal policies is necessary to better understand and explain tight financial conditions. This could explain why the current economic and financial situation differs significantly from past years.
Firstly, it's crucial to note that the Federal Reserve's balance sheet remains substantial, at close to $7 trillion. This is approximately $4 trillion higher than its level four years ago. While the Fed's balance sheet is no longer expanding and is gradually shrinking, its impact on financial markets should not be underestimated. The additional $4 trillion of Fed security holdings equates to $4 trillion of liquidity for private investors seeking other investment opportunities.
Second, the US budget deficit is running at about $1.9 trillion. Not every dollar of government spending shows up in GDP, but what does not goes into the hands of people and businesses, and their spending does show up. Also, when the government runs a deficit, it means that people and businesses are not being taxed to an equal amount for the level of government spending. So, the bottom line is that budget deficits enable people's and businesses' cash flow to be higher than otherwise would be the case.
The Fed's balance sheet and the Federal government deficit together amount to over 30% of nominal GDP, which is enormous. The only times it was larger were during the pandemic years.
Using interest rate levels as the traditional method to gauge tight financial conditions is no longer relevant. The current unprecedented stimulus from monetary policy, achieved through asset purchases, and from fiscal policy, due to a relatively large budget deficit, makes it difficult to determine what defines tight financial conditions. It is challenging to ascertain if financial conditions are tight until the combined stimulus falls below pre-pandemic levels (or well below 20% of Nominal GDP).
Joseph G. Carson
AuthorMore in Author Profile »Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.
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