How Markets Respond to Monetary Policy

The Federal Reserve’s been tightening monetary policy since 2015, yet economic growth remains solid.

The economy’s resilience after the Fed’s tightening is a mystery to a number of investors and analysts, but it shouldn’t be. It’s a normal part of the economic cycle.

The federal funds rate has been increased six times since the Fed started to tighten its policy, and expectations are for another three or four increases in 2018. Last week, the 10-year and 30-year Treasury bonds spiked higher, hitting their highest yields in several years.

Despite this tightening, the economy continues to grow. Although growth has slowed a bit so far in 2018, as you’ve seen in these weekly updates, it accelerated through 2017 even as the Fed increased rates. Consumers and businesses still report being optimistic about the current situation and the future. The unemployment rate and new unemployment claims remain near record lows.

There’s no mystery. It always takes time for changes in monetary policy to have the intended effect on the economy. Usually, it takes about two years for a tightening by the Fed to begin reducing economic growth. But these aren’t normal times. When the economy is suffering the effects of extreme debt and a financial crisis, as we are now, the lags are even longer.

Another effect that puzzles investors is that inflation will rise even as the Fed continues to tighten policy and economic growth slows. Eventually, the tighter monetary policy leads to a recession, but inflation normally continues rising after the recession begins. Often, it isn’t until the recession is well underway that inflation starts to decline.

The Fed’s policy changes have more immediate effects on the financial markets than on the economy. Many investors make the mistake of waiting to see changes in the economy before changing their portfolios. But the usual pattern is for Fed policy changes to be felt in the markets before they are reflected in economic data.

We saw that effect in 2009 after the Fed began quantitative easing. Stock prices began to rise well before the economy did, and stock gains have exceeded economic growth. More recently, the economy has continued to grow while stock prices have stalled and bonds have delivered negative returns. Again, that’s normal. Financial markets tend to anticipate the future. Also, higher interest rates cause investors to recalculate their investment positions. When interest rates on risk-free assets such as treasury bills rise, investors demand higher potential returns from other investments.

There’s no telling how long it will take the economy to slow after rates rise. Each cycle is a bit different from the others. Unlike in the past, this time the Fed wants to avoid triggering a recession. The economy is too fragile, and the Fed doesn’t have as many tools to reverse a decline as it usually does. As I’ve said for several years, the greatest risk is that the Fed may tighten too much.

We do know that once the Fed tightens, stocks and bonds begin to suffer, as they have the last few months. If higher interest rates cause growth to tumble, interest rates will start to decline again. Then, it will be a good time to own bonds.

Note: I prepared this week’s Journal entry a day early because of travel obligations. The economic and market data are through the close of Wednesday. I’ll report the rest of the week’s data next week.

The Data

There were only a few economic reports so far this week.

The Richmond Fed Manufacturing Index joined the Fed regional bank surveys showing robust rebounds. The index jumped to 16 after registering negative 3 last week. All components of the index were strong, and almost all were higher than last month.

New home sales continue to be volatile from month to month but over time show a trend of steadily higher sales. In the latest report, sales were down a bit and the previous two months’ sales were revised down. But, as I said, sales of new homes are 11.6% above the level of 12 months ago. There was some price discounting in the latest sales. Prices dropped 6.9% in the last month and are up only 0.4% over 12 months.

The PMI Composite Flash Index for mid-month indicates growth is higher across the board. The manufacturing component increased to 56.6 from 56.5, and services increased to 55.7 from 54.4. Each is near highs for this cycle.

The Markets

The S&P 500 rose 0.41% for the week ended with Wednesday’s close. The Dow Jones Industrial Average added 0.55%. The Russell 2000 returned 0.65%. The All-Country World Index declined 0.14%. Emerging market equities dropped 1.46%.

Long-term treasuries increased 0.98% for the week. Investment-grade bonds gained 0.61%. Treasury Inflation-Protected Securities (TIPS) returned 0.36%. High-yield bonds rose 0.25%.

The dollar increased 0.61%.

Energy-based commodities rose 1.11% for the week. Broader-based commodities returned 1.90%. Gold added 0.16%.

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