Market monetarists favor a policy regime where the instrument setting creates a policy stance that the financial markets believe will achieve the Fed’s policy goal. Thus, if the Fed’s goal is 2% inflation, then the monetary base (or the fed funds target) should be set at a level that the market believes will result in 2% inflation.
Is the Federal Reserve beholden to short-term volatility in the financial markets?
A handful of Fed-watchers argue that the answer is yes, based on language from the Federal Open Market Committee’s meeting minutes released Wednesday. They point to two words: “premised importantly.”
“Revealingly, participants noted that low borrowing costs and high equity prices were ‘premised importantly’ on expected Fed rate cuts,” Capital Economics’ Michael Pearce wrote on Wednesday. “Translation: The Fed is petrified of upsetting the markets and will therefore continue cutting rates.” (emphasis added)
Here’s the full quote from the July FOMC minutes for context: “Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks.“
Rather than say the Fed is “petrified of upsetting the markets”, it would be more accurate to say the Fed increasingly recognizes that market forecasts are superior to its failed Phillips Curve models. The markets expect sub-2% inflation over the next 5 years, and also predict several more rate cuts.
In other words, the markets are saying that Fed policy is likely to be too tight to hit their inflation target, and also that this excessively tight Fed policy will involve several more rate cuts. In that case, it would be a huge mistake for the Fed to be tighter than the market currently expects. Indeed, the Fed may wish to be even more expansionary than the market expects.
While I wish the Fed was even more beholden to the financial markets, this is clearly a positive step toward a more market monetarist policy regime.
PS. Fed funds futures currently show that investors expect T-bill prices of roughly 99 by the end of 2020. That implies a market consensus that T-bill yields will have fallen to roughly 1% by that date: