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Writer's pictureJoe Carson

What Constitutes Tight Financial Conditions? Using Interest Rates Alone Is No Longer Relevant

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).

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