NEW YORK – The link between the fed funds rate and financial indicators must be stable and predictable in order to predict future economic activity, Federal Reserve Bank of New York President William C. Dudley said today.
“Monetary policy works its magic through its effect on financial conditions; it does not operate directly on real economic variables,” Dudley told a University of Chicago forum today, according to prepared text of his remarks, which were released by the Fed. “That is because the level of the federal funds rate influences other financial market variables such as money market rates, long-term interest rates, credit spreads, stock prices and the value of the dollar, and it is these variables that influence real economic activity. This means that if the linkage between the fed funds rate and this broader constellation of financial indicators is not stable or completely predictable, then knowing what is happening to the fed funds rate is not sufficient to predict economic activity.”
Instability means “these indicators provide additional information about real activity and also are relevant in deciding the appropriate fed funds rate target,” he said, while “if the transmission mechanism from the fed funds rate to financial conditions and onward to real economic activity were completely predictable, then there would be no need to focus on financial conditions as an intermediate target variable. The level and path of the fed funds rate matters, but it also matters how this gets transmitted to the real economy through the financial sector.”
There have been two significant divergences in the past 15 years, he said, in the late 1990s around the technology stock market bubble and its aftermath, and in the mid-2000s credit market bubble that culminated in the recent financial crisis. “During these episodes, the relationship between the fed funds rate and financial conditions was particularly unstable,” Dudley said. “As a result, developments in the financial markets became very important in the conduct of monetary policy.”
When the economy is stable, then markets have more appetite for risk. “However, when a recession finally arrives, it is a bigger shock than when recessions were more frequent. This surprise results in a more substantial adjustment in financial conditions. Ironically, the increased stability of the business cycle during the expansion phase appears to increase the volatility and importance of financial conditions when recessions do occur,” he said.
“Events of the past decade confirm that financial conditions matter and that the fed funds rate is not a sufficient statistic with which to assess the impact of monetary policy on the real economy,” Dudley added. The Federal Reserve, he said, “has explicitly taken financial conditions into account in its conduct of monetary policy.”
