The Fed Says Vs. The Fed Does – Just How Restrictive Is Monetary Policy Today?

All Federal Reserve spokespersons refer to the current monetary policy stance as “restrictive”.  Financial conditions suggest otherwise.

Today, the Real Federal Funds Rate is 1.85% (nominal rate less CPI).  The Real Rate peaked near 4% in mid-1998 and in late 2006.  Otherwise, the most “restrictive” real rates occurred in the late 1970s through the early 1980s as Fed policy desperately fought inflation.  A Real Rate between 4% and 8% was not unusual.  

Based on history, we agree that the Fed policy rate is restrictive, but not unusually high. However, a ”restrictive” Federal Funds Rate doesn’t necessarily translate to financial conditions, which provide greater context into the economic impact of monetary policy.

Financial conditions are measured by several respected entities, including the Federal Reserve itself.  The Chicago Federal Reserve Bank calculates one such index, the National Financial Conditions Index (NFCI). The Chicago Fed’s NFCI provides a “comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems”.  Negative values of the NFCI indicate financial conditions are looser than average, while positive values indicate financial conditions are tighter than average.

You will note in the chart (click to enlarge) that the current Financial Conditions Index level of -0.5 fits squarely in the 0 to -1.0 range associated with normal or moderately loose market-based measurements of financial conditions.  In perspective, financial conditions spiked to 0.5 during the pandemic and 2.75 during the great financial crisis.  Conditions in the  +2 to +4 range were the norm during the late 1970s to mid-1980s, with Real Fed Funds Rates between 4% and 8%.

Obviously, financial conditions can change – and they can change quickly in times of crisis. But current market-based measurements of financial conditions do not support the Fed’s claim of a “restrictive” policy stance.

Source: Federal Reserve Bank of St. Louis

A chart comparing the Chicago Federal Reserve's National Financial Conditions Index versus the Real Federal Reserve Fund Rate.

Source: Federal Reserve Bank of St. Louis

You will note in the chart that the current Financial Conditions Index level of -0.5 fits squarely in the 0 to -1.0 range associated with normal or moderately loose market-based measurements of financial conditions.  In perspective, financial conditions spiked to 0.5 during the pandemic and 2.75 during the great financial crisis.  Conditions in the  +2 to +4 range were the norm during the late 1970s to mid-1980s, with Real Fed Funds Rates between 4% and 8%.

Obviously, financial conditions can change – and they can change quickly in times of crisis. But current market-based measurements of financial conditions do not support the Fed’s claim of a “restrictive” policy stance.

Conclusions And Relevance To Your Portfolios

With relatively loose financial conditions, persistent inflation, and an economy that continues to defy recession indicators, the Fed will not be able to justify cutting rates in line with market expectations (two, down from six earlier this year).

The reality is that no one knows how long it will take to reverse 14 years of accommodative monetary policy, which has force-fed the global economy since the Great Financial Crisis. Until the data shows inflation nearing the Fed’s target, we expect a higher Fed Funds Rate to remain, along with the potential risks of the higher rate environment.

Considering the changing valuation between stocks and bonds (market overvaluation vs. higher risk-free rate) and no measurable justification for significant rate reductions, a less aggressive exposure to the stock market is warranted. In response, AAMA recently reduced the target equity exposure within our Balanced allocation strategy from a neutral 60% to 50% (10% above the minimum equity exposure).

AAMA’s equity portfolios remain focused on large cap companies, with a tilt toward defensive sectors and an emphasis on balance sheet quality. While the market is widely overvalued, there are segments of the market with stronger earnings forecasts and/or lower earnings and price volatility. Healthcare is an example, with a double-digit earnings growth forecast, moderate short- and long-term price volatility, and just half the earnings volatility of the S&P 500.

AAMA’s income portfolios remain positioned in short-term and high-quality debt instruments — a strategy initiated several years ago to reduce the risk to principal in a rising rate environment. The prolonged inflation fight provides confirmation for our fixed income positioning, which has avoided much of the volatility recently seen in longer-maturity bonds.

Want To Learn More?

If you would like to learn more about our fundamentally-rooted investment process, our risk-adjusted portfolios, or our views on the markets and economy, click here to contact us. We’d love to speak with you.

The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.

Stay Up to Date

Want to stay up to date with fundamentally-driven market insight, economic analysis, and practice management advice? 

Sign up to receive regular roundups of our content, delivered conveniently to your inbox.