ACTV - Understanding The 'Sufficiently Restrictive' Phrase

2023-04-18 05:00:00 ET

Summary

• U.S. Bank loans and leases declined by $105 billion in the two weeks following the banking system disruption, suggesting some downward pressure ahead for the U.S. economy.
• A plus 1% spread between the 1-year and the 10-year is a sign of a meaningfully restrictive policy, and the banking system has felt the effects.
• The path of inflation is receding, even if the progress may be slow and a little bumpy, so the gap between core inflation and short-term rates may well widen as the year progresses.

By Blu Putnam

The Federal Reserve has guided that it will raise rates until its policy is “sufficiently” restrictive. Monetary policy already appears restrictive. We will wait on the Fed to tell us if this is sufficient.

The yield curve, with short-term rates higher than long-term yields, has been inverted since November 2022. An inverted yield curve is a reliable indicator of a restrictive policy by virtue of its track record of anticipating past recessions.

Indeed, the increase in interest rate risk associated with an inverted yield curve has already negatively disrupted the banking sector. U.S. bank lending slowed noticeably in the weeks following the failure of several banks in early March. While bank credit is not a reliable indicator, the current lack of loan growth does suggest that the interest rate policy is having an impact.

More recently, with the release of the PCE core inflation metric for February 2023, the federal funds rate is above the Fed’s favorite measure of inflation. A positive real interest rate, or inflation-adjusted rate, is another accepted measure of a restrictive policy. Moreover, the path of inflation is receding, even if the progress may be slow and a little bumpy, so the gap between core inflation and short-term rates may well widen as the year progresses.

For some, the robust growth of jobs in the U.S. economy and the historically low unemployment rate is an indicator that monetary policy is not so restrictive. We would note, however, that the perceived link between job growth and inflation has not been apparent in the economy since the early 1990s, and prices led wages this time around. Any pressure on wages may well be felt in reduced profit growth, which could constrain equity markets and may not necessarily flow through to inflation.

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