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Don't Look Now, But Monetary Policy Is Tightening Dramatically

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by: Scott Sumner
Summary

Policy has dramatically tightened in recent weeks.

Perhaps the most startling data point is the expected level of interest rates in the Fed Funds futures market, which has plunged to barely over 1% in 2021.

It's likely that the low expected rate partly reflects some factors unrelated to US NGDP growth, say global weakness, but I wouldn't count on that explaining all of the drop.

While most of the economics profession seems to assume that a Fed cut in interest rates means money is getting easier, policy has dramatically tightened in recent weeks.

Perhaps the most startling data point is the expected level of interest rates in the Fed Funds futures market, which has plunged to barely over 1% in 2021. Consider that figure to be a prediction that NGDP growth in 2021 will be weak enough to justify such a low policy rate. Sorry, no more "one and done".

Yes, it's likely that the low expected rate partly reflects some factors unrelated to US NGDP growth, say global weakness, but I wouldn't count on that explaining all of the drop. Lots of other indicators also point to slowing growth in NGDP. Five-year TIPS spreads are down to 1.41%, consistent with roughly 1.15% PCE inflation. Again, TIPS spreads are somewhat biased, but do contain at least some information about inflation expectations. Stocks are also selling off, albeit from a fairly high level. While no single indicator is definitive, the overall picture is of a decline in aggregate demand (and aggregate supply as well). We are seeing the income and Fisher effects in action.

It's now pretty clear that the Fed should have cut rates by 0.5% last week. In fairness, the latest demand shock came from the renewed trade war, which occurred after the meeting.

The lesson here is that the Fed should adopt my proposal to adjust its Fed Funds target daily, to the closest basis point. Time to join the 21st century.

Update: When the news starts to look like this...

... it's not a good sign. Oh, and Boris Johnson seems determined to drive the UK into a hard Brexit, while the eurozone continues to be dysfunctional.

Have a nice day!

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.