Inside the dynamic $31 trillion American economy, policy must evolve as the economy changes.
One of these changes is that risk markets have become less sensitive to changes in interest rates as fiscal policy takes center stage amid a profound demographic and technological shift.
For this reason, the transmission mechanism of monetary policy into the real economy has become less effective.
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When the fiscal authority like Congress acts as a partner with the monetary authority like the Federal Reserve, the transmission mechanism tends to work well, though with long and variable lags.
But when the fiscal authority is at odds with monetary authority, then the transmission mechanism starts to break down.
For example, when government debt and deficits escalate, the nation’s fiscal condition starts to limit what the central bank can and cannot do.
Monetary policy is then placed in a subordinate position to the financing needs of the economy, which distracts the central bank from fulfilling its dual mandate of maintaining price stability and maximum sustainable employment.
In addition, the rising debt burden leads to debt monetization and higher inflation in the medium to long run.
There are periods, like during wartime or a pandemic, when it is appropriate for an aggressive fiscal policy. Yet such policies should be discussed in the full light of day so investors and the public can make informed decisions.
Over the past 70 years, both fiscal and monetary authorities have moved away from the shadows of wartime interventionist policies like price controls to relying on market decision-making.
The responsibility for maintaining price stability and full employment has now fallen to the apolitical Federal Reserve, and it has largely achieved its goal.
The Fed, for example, vanquished runaway inflation in 1980 and, more recently, has achieved decades of subdued inflation centered on its 2% target and an unemployment rate consistently under 5%.
Without government involvement, the 12-member Federal Open Market Committee sets the Fed’s overnight policy rate eight times a year. The Fed’s forward guidance sustains expectations of Fed policy, with a positive effect of increased confidence allowing the financial system and commercial sector to make rational investment decisions.
The Fed’s policy rate decisions no longer seem capricious. By the time of each FOMC meeting, its intentions are already well known, via the notes of the previous meeting’s decision and by speeches between meetings.
So, what exactly happens when the Fed cuts or increases its policy rate?
First, Wall Street and the banking industry have already dissected the FOMC minutes and speeches and have a good idea of what to expect.
The FOMC has seldom strayed from its formula of research and discussion; forward guidance; and the scheduled implementation of its policy.
So when the Fed hikes the federal funds rate, the immediate response comes from the financial markets, where higher interest rates tighten financial conditions.
The increased cost of short-term credit puts a damper on consumer spending while the increased cost of capital will moderate business investment, leading to reduced economic activity and downward pressure on inflation.
In the case of a rate hike, concerns over slower economic growth and fewer employment opportunities lead to reduced demand for consumer goods and therefore lower inflation rates.
If the Fed sees the need to cut rates, the easing of financial conditions will lead to an increase in investment, consumption and economic activity, with upward pressure on inflation.
The monetary transmission system can be aided by fiscal policy in the best case or restricted by a counter-productive fiscal policy.
We see this example in unfunded tax cuts injecting cash into household balance sheets that will increase the demand for goods, pushing inflation higher.
The takeaway
Fed policy is transmitted to the economy by first affecting the degree of financial tightening or accommodation. Tighter financial conditions tend to limit economic activity. Accommodative financial conditions have been shown to increase economic activity.
But for that system to run smoothly, policy from the monetary and fiscal authorities must work as partners and not through a series of inconsistent policy initiatives and interventions.
