Why does the economy continue to boom despite tight monetary policy?

Author: Alp Simsek, Professor of Finance, Yale School of Management

Compiled by: Tia, Techub News

Editor’s Note:

In the current global economic situation, the Federal Reserve's monetary policy has received unprecedented attention. Despite the policy interest rate has risen to a historical high, the US economy has remained strong, a phenomenon that seems to go against the expectations of traditional economic theory. The continued hot job market and steady economic growth make people wonder: Why has the tight monetary policy failed to curb the overheating of the economy as effectively as before? The latest research points out that the reason behind this phenomenon is not a paradox, but the limitations of the traditional analytical framework. By re-examining the impact of financial conditions on the economy, we can gain a deeper understanding of the actual transmission mechanism of monetary policy.

The Federal Reserve has raised interest rates to historic levels, but the economy is still moving upward. The current strong jobs report is proof of this. Why is this happening?

According to ourLatest Papers, perhaps because we are focusing on the wrong metrics.

Although policy rates are high, financial conditions are actually quite accommodative. Rising stock markets and tighter credit spreads have effectively offset much of the Fed’s tightening.

Data shows that the Fed's own FCI-G index (an index that combines financial variables to measure their impact on economic growth) confirms this. Although long-term interest rates are rising and the dollar is strengthening, the positive performance of the market (mainly the stock market boom and the improvement of credit spreads) is stimulating economic growth.

Tight monetary policy and strong growth are not actually a paradox.

In our conversation with Ricardo Caballero and@TCaravelloshows that what matters to the economy is not the policy rate itself, but the broader financial conditions.

Our analysis suggests that when financial conditions loosen, even if driven by noisy asset demand (sentiment), they boost output and inflation, eventually forcing interest rates higher. This is consistent with what we see today.

From a quantitative perspective, the study found that financial conditions account for as much as 55% of the impact on economic output fluctuations.

In addition, the main transmission method of monetary policy should be to influence financial conditions rather than directly through interest rates.

Current conditions fit within this framework: despite higher interest rates, accommodative financial conditions are supporting strong growth and are likely to prevent inflation from returning to target.

Looking ahead, this suggests that the Fed’s work is not yet done. To achieve the goals of 2%, financial conditions may need to tighten.

This could be achieved through: market correction – stronger dollar – further rate hikes.

The path of interest rates will depend largely on market dynamics. If markets adjust and the dollar strengthens, current interest rate levels may be sufficient. But if financial conditions remain accommodative, further rate hikes may be needed.

This framework suggests that Fed watchers should focus less on the debate over the “terminal rate” and more on the evolution of financial conditions. This is where the real transmission of monetary policy occurs.

While our paper goes a step further by proposing an explicit FCI target, more importantly, we need to change the way we think and talk about monetary policy. The policy rate is just one input; financial conditions are what really matter.

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