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Financial conditions matter more than interest rates: A new framework for monetary policy

Despite the sharp tightening of the Federal Reserve’s policy rate, the US economy has shown remarkable resilience, sparking a debate about whether monetary policy is as restrictive as conventional measures suggest. This column suggests that households and firms react to changes in financial conditions rather than the policy rate itself. Policy discussions should focus on financial conditions rather than the policy rate. When the central bank commits to a path for financial conditions, it reduces volatility and encourages stabilising trades.

The Federal Reserve’s policy rate stands at 4.5%, dramatically higher than its pre-COVID level of around 1.5%–2%. This sharp tightening led many economists to predict, since 2022, an imminent recession in the US. As recently as August 2024, amid a market sell-off, forecasters were still warning of a potential downturn (Bloomberg 2024). Yet the ‘imminent’ recession never materialised. Instead, the economy has shown remarkable resilience – evidenced by continued strong output and job growth along with above-target inflation – forcing the Fed to delay anticipated interest rate cuts (Figure 1).

Figure 1 High policy rates and the ‘recession’ that never materialised

Figure 1 High policy rates and the ‘recession’ that never materialised
Figure 1 High policy rates and the ‘recession’ that never materialised

This sustained economic strength in the face of high policy rates has sparked a debate about whether monetary policy is as restrictive as conventional measures suggest. Some argue that the natural rate (‘r-star’) may have risen substantially from its pre-COVID level (Benigno et al. 2024).

Our recent work (Caballero et al. 2024) suggests a different explanation: we’ve been looking at the wrong indicator. In practice, monetary policy works through financial conditions: when the Fed changes the policy rate, it induces changes in corporate borrowing rates, stock prices, mortgage rates, house prices, the dollar, and so on. Households and firms react to these changes in financial conditions rather than the policy rate itself.

While policy rates and financial conditions are often correlated, this relationship has broken down recently. The dramatic stock-market rally of the last two years (with prices up more than 50%) and the associated decline in credit spreads have helped loosen financial conditions despite relatively high rates and a strong dollar. This disconnect is confirmed by the Fed’s Financial Conditions Impact on Growth (FCI-G) index, which aggregates financial variables based on their impact on future GDP growth (Ajello et al. 2023). According to this index, financial conditions loosened significantly throughout 2024, becoming stimulative for the economy even amid elevated policy rates (Figure 2).

Figure 2 FCI-G has loosened throughout 2024, mainly due to the stock market boom and low credit spreads

Figure 2 FCI-G has loosened throughout 2024, mainly due to the stock market boom and low credit spreads
Figure 2 FCI-G has loosened throughout 2024, mainly due to the stock market boom and low credit spreads

This financial markets perspective generates new challenges for monetary policy. Financial conditions indices like FCI-G are primarily driven by stock prices and exchange rates (see Caballero and Simsek 2024 for a review), which tend to be more volatile than bond prices. A long tradition in finance since Robert Shiller shows these risky asset prices exhibit ‘excess’ volatility. This volatility partly emerges from ‘noise’ – supply and demand effects unrelated to fundamentals. These include retail investor sentiment-driven trading, institutional investors’ mechanical portfolio rebalancing needs, and fund flows driven by client redemptions or contributions.

Recent work by Gabaix and Koijen (2021) shows that such noisy demand can explain substantial stock market volatility. Building on their measure, we show that noisy demand affects not just stock prices but broader financial conditions, output, inflation, and the policy interest rate. When noise raises the stock market and loosens financial conditions, it stimulates output and generates inflationary pressures, eventually inducing the Fed to raise the policy rate, consistent with recent experience (Figure 3).

Figure 3 Impulse response to a positive noisy demand shock for the stock market

Figure 3 Impulse response to a positive noisy demand shock for the stock market
Figure 3 Impulse response to a positive noisy demand shock for the stock market
Notes: Shaded and light-shaded grey bands indicate 68 and 90 confidence sets, respectively. See Caballero et al. (2024) for details.

While we cannot confidently say whether the current stock boom reflects noise or expectations about AI’s impact on future earnings, our analysis demonstrates that market movements – whatever their source – affect the economy through financial conditions. In fact, we show that noisy financial flows alone can explain between 20% and 50% of the variance of the US output gaps.

How should monetary policy respond?

The prevailing wisdom, articulated by Bernanke and Gertler (2001), is that policy should focus on inflation targeting and incorporate financial conditions only to the extent they affect output and inflation. We go further, providing a rationale for explicit financial-conditions targeting.

Financial conditions targeting refers to a policy framework where the central bank announces a target level for the financial conditions index and adjusts the policy rate to keep conditions close to this target while still attending to its usual objectives. As macroeconomic conditions evolve, the central bank updates its target, but in the short run, it maintains its commitment – deliberately introducing a small delay in its response to macroeconomic news. We show that this framework improves policy performance and helps stabilise output and inflation gaps, even though stable financial conditions are not a policy objective in themselves.

The key insight is that when the central bank commits to a path for financial conditions, this reduces their volatility. Lower volatility enables arbitrageurs to trade more aggressively against noisy demand that affects financial conditions, since they face less risk in taking these positions. This creates a virtuous cycle: more aggressive arbitrage trading further reduces volatility, which in turn encourages even more stabilising trades. Through this ‘recruitment’ effect, the central bank effectively enlists market participants to help stabilise financial conditions before policy needs to act. This mechanism works without requiring the Fed to identify in real time whether market movements are driven by noise or fundamentals (including expectations about future productivity gains).

How might this work in practice?

Consider a soft form of financial conditions index targeting, where the Fed provides guidance on its near-term expected level of the FCI-G index. Drawing on its experience with interest rate forward guidance, the Fed could offer a degree of commitment – aiming to keep conditions close to its guidance while retaining flexibility to respond to major macroeconomic developments. Once the Fed communicates its desired financial conditions index level, sophisticated market participants would likely construct and trade portfolios of assets (or their proxies) to maintain the index near the Fed’s target. Banks could readily create tradable financial conditions index-mimicking baskets to facilitate trading deviations from the Fed’s guidance.

Crucially, this framework accommodates substantial relative price movements and price discovery within individual markets. For instance, stock prices might rise while bond prices fall, yet the financial conditions index could remain unchanged. This approach ensures that the appropriate weighted average of these prices – the financial conditions index – stays insulated from noise and aligned with the Fed’s macroeconomic objectives.

Our counterfactual analysis shows that when the Fed targets financial conditions, noise shocks have a smaller impact on financial conditions, output gap, inflation, and interest rates (Figure 4). Importantly, since arbitrageurs anticipate the Fed’s response, they help stabilise conditions before policy needs to act. Through this recruitment effect, financial-conditions targeting can achieve better macro outcomes without necessarily requiring more volatile interest rates. In fact, once we incorporate the risk reduction due to the recruitment effect, an increase in noisy asset demand induces a frontloading of interest rates but not necessarily higher rates (see beige vs blue line in Figure 4).

Figure 4 Counterfactual Impulse Responses to a positive noisy demand shock for the stock market under FCI targeting

Figure 4 Counterfactual Impulse Responses to a positive noisy demand shock for the stock market under FCI targeting
Figure 4 Counterfactual Impulse Responses to a positive noisy demand shock for the stock market under FCI targeting
Notes: Beige: not accounting for endogenous risk reduction due to the ‘recruitment effect’. Blue: accounting for the endogenous risk reduction.

While our paper advocates for explicit financial-conditions targeting, the immediate takeaway is simple: policy discussions should focus on financial conditions rather than the policy rate. Although policymakers already monitor financial conditions, they do not announce their desired levels. This creates potential misunderstandings and allows noise to affect conditions more than necessary. Even without full targeting, enhancing Fed communication by announcing ‘appropriate financial conditions’ could activate the recruitment effect. The policy conversation needs to shift from appropriate policy interest rate (‘r-star’) to appropriate financial conditions (‘FCI-star’), as discussed in Caballero and Simsek (2017, 2020, 2022). When markets understand where the Fed aims to guide financial conditions, they are more likely to do a better job keeping them there.

Source : VOXeu

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