Mary Daly, Essay: Resolute and Mindful: The Path to Price Stability

Forward Guidance

“This and other forward guidance provided throughout that fall had an immediate impact. Almost overnight, financial conditions tightened. Market participants began pricing in expected future rate hikes, and businesses and households started readying themselves for a new interest rate landscape, pulling forward real estate purchases, restructuring debt obligations, and locking in longer-term fixed-rate loans. In other words, before we ever raised the federal funds rate, tighter financial conditions were already working their way through the system. Indeed, by the time of the first official rate hike of 25 basis points in March 2022, mortgage interest rates had risen three-quarters of a percentage point and broader financial conditions had tightened almost a full percentage point. The responsiveness of financial conditions to our communications was notable and helpful.”

Cumulative Tightening

“Let’s start with cumulative tightening. Historically, we’ve used progress on the federal funds rate and where it stands relative to its neutral value as a gauge for policy restrictiveness. But in today’s world, that is only part of the picture. The funds rate does not capture the impact of the other tools in our tool kit, including the reduced asset holdings associated with balance sheet roll-off and the forward guidance we’ve provided about the future path of policy. It also misses the fact that central banks across the globe are tightening policy as well, likely amplifying the effects of our own rate hikes.”

“A more comprehensive way to gauge the actual level of tightening is to look at financial market conditions (see Choi et al. 2022 and the San Francisco Fed’s Proxy Funds Rate data page). Several researchers have done this and found that the level of financial tightening in the economy is much higher than what the funds rate tells us. As the figure shows, this has been true for a while now. In fact today, while the funds rate is between 3.75 and 4%, financial markets are acting like it is around 6%.”