INSIGHTS AND RESOURCES

Changes in Fed policy and their impact on the economy

REAL ECONOMY BLOG | June 17, 2022

Authored by RSM US LLP


After more than a decade of disinflation and the threat of deflation, the Federal Reserve is now dealing with persistent inflation resulting from a pandemic-induced supply chain shock, a surge in consumer demand and yet another oil shock.

This has resulted in an abrupt shift in policy to restore price stability. In the process, that shift has raised the probability that the economy will slow on the back of rising interest rates and tightening financial conditions.

CPI

Because of these shocks to price stability, the Fed recently raised its overnight policy rate by 75 basis points, its biggest increase since November 1994. With few exceptions, the Fed has preferred to gradually raise rates by 25 basis points to maintain growth and full employment. That is not going to be the case in the near term.

Fed and inflation

These policy-induced changes to short-term interest rates will affect the stock of money, which directly determines the direction of the real economy, output and employment.

The relationship between policy and the monetary-policy transmission mechanism is complex. But it has an unmistakable impact on the broader economy, affecting not only interest rates but also exchange rates, equity prices and real estate values, as well as bank lending and firms’ balance sheets.

The direction of significantly tighter financial conditions through the remainder of the year implies that the probability of a recession is rising as these conditions take hold in the real economy.

We expect the Fed to hike its federal funds policy rate by 50 basis points in July and then again in September, so market participants and firm managers should anticipate a further tightening of financial conditions.

RSM US Financial Conditions Index

In addition, the Fed’s drawdown of its holdings of Treasury bonds and mortgage-backed securities began in June. The increase in the supply of T-bills and bonds in the market will gradually reduce the downward pressure on short-term and longer-term interest rates.

Fed balance sheet

Because longer-term interest rates are determined as the present value of the anticipated path of short-term rates (plus a premium for the risk of holding those securities until maturity), increasing the federal funds rate will pressure interest rates higher all along the yield curve.

Raising the overnight rate will have a greater impact on shorter-term securities than on 10-year bond yields, which are reacting more to expectations of long-term growth.

Regardless, the higher costs of investing and consumer credit will act as a drag on economic activity, resulting in lower demand for goods and services and lower rates of inflation.

Fed funds rate and 10-year yields

Because of their proximity to the federal funds rate, two-year bond yields are considered a proxy for expectations for the funds rate in two years’ time. So the current two-year yield of just over 3.1% suggests how far the Federal Reserve will push its policy rate to resolve the surge in inflation.

Economic and financial analysts will note that with 10-year bond yields at 3.2%—and just 10 basis points higher than 2-year yields—implies a near-inversion of what is normally an upward-sloping yield curve. They note that these yield curve inversions have occurred before each recession. But they do not always accurately predict the onset of a recession.

We think these yield curve inversions should not be thought of as the cause of a recession, but as late-cycle anticipation of slower growth.

Yield spreads, 2 and 10 year

It is also true that, in the current episode, the Fed had begun the process of normalizing interest rates after years of emergency measures to keep interest rates at near-zero levels. And now—because of the need to prevent the embedding of inflation expectations—there is the need to quickly increase short-term rates.

For this reason, we expect a flatter yield curve than normal, at least until inflation is pushed back toward the Fed’s 2% target.

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This article was written by Joseph Brusuelas and originally appeared on 2022-06-17.
2022 RSM US LLP. All rights reserved.
https://realeconomy.rsmus.com/changes-in-fed-policy-and-their-impact-on-the-economy/

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