Bloomberg.- William Dudley, president of the Federal Reserve Bank of New York, has long believed that Fed policymakers should pay more attention to stock market swings. Now, with the Fed lifting rates for the first time in almost 10 years, Dudley, who also serves as vice chairman of the Fed’s Open Market Committee, has a chance to put his ideas into practice.
The Fed has a dual mission: to keep unemployment low and prices stable, which it tries to accomplish mainly by making changes in a key lending rate, the federal funds rate. To assess the economy, it examines data such as monthly reports on the job market and consumer spending. It doesn’t put a lot of weight on stock prices, which can be volatile, plunging and soaring from day to day, sometimes for no apparent reason.
Yet market swings can make investors feel poorer or richer, influencing their willingness to spend money. Because that may give an earlier signal on the direction of the economy than statistics such as consumer spending, Dudley thinks the Fed should factor what happens on Wall Street into its monetary policy deliberations. If it does—and with the stock market up more than 10 percent since Donald Trump’s election—the Fed could raise interest rates higher, or more quickly, this year than other statistics might indicate.
“Animal spirits in financial markets wax and wane, pushing asset values up or down in a manner that can more than offset the effects of movements in short-term interest rates,” Dudley said in a speech titled The Importance of Financial Conditions in the Conduct of Monetary Policy on March 30. “The movements in many financial markets following last year’s presidential election are a notable example of this phenomenon.”
In the 1990s, while serving as chief economist at Goldman Sachs Group Inc., Dudley became intrigued with work done at Canada’s equivalent of the Federal Reserve. The country’s central bankers had a communications problem: Capital flows in international financial markets were leading to swings in the Canadian dollar, affecting the ability of businesses to export goods and services to the rest of the world. Those shifts could overwhelm the Bank of Canada’s attempts to guide the economy using its traditional tool—tightening or loosening monetary policy by raising or lowering the short-term interest rate—according to Charles Freedman, deputy governor of the bank from 1988 to 2003.
Canadian businesses benefiting from a weaker exchange rate, for example, might not get the message the bank was trying to send by raising rates. “To get that point across, we developed a ‘monetary conditions index,’ which basically put the two channels together,” so the public could compare the economic effects of interest rates with those of swings in the currency, says Freedman, who’s now a scholar-in-residence at Carleton University in Ottawa. “Someone could look at that measure and say, ‘Interest rates haven’t moved, but the exchange rate did move, and therefore market and monetary conditions have eased—or tightened depending on which direction we’re going,’ ” he says.
The idea caught on fast on Wall Street, including at Goldman Sachs. In an October 1996 speech at Princeton, Dudley argued that “Fed officials should evaluate carefully the implications of changes in financial asset prices on the performance of the real economy,” according to a summary of his remarks. He cited indexes that Goldman economists developed to track interest rate and currency developments in several countries. Those monetary conditions indexes owed “a big debt to the path-breaking work of the Bank of Canada, in general, and Chuck Freedman, in particular,” he said.
In February 1998, after congressional testimony by then-Fed Chairman Alan Greenspan, Dudley and his Goldman team went a step further. Greenspan told Congress that though inflation-adjusted interest rates had risen, “in virtually all other respects financial markets remained quite accommodative and, indeed, judging by the rise in equity prices, were providing additional impetus to domestic spending.” Those comments spurred Dudley’s team to add a stock market measure to their monetary conditions index, transforming it into a “financial conditions index.”
Dudley still relies on the index, and there are signs Fed Chair Janet Yellen is paying attention. Following the FOMC’s March 15 rate hike, Yellen told reporters “the higher level of stock prices is one factor that looks like it’s likely to somewhat boost consumption spending,” citing “some of the more prominent analysts and indices” that have showed overall financial conditions are improving, despite recent rate increases.
One of the analysts she was referring to was almost certainly Jan Hatzius, who worked for Dudley at Goldman, helping him to refine the financial conditions index and succeeding him as the bank’s chief economist in 2005. Hatzius says if the index continues to indicate improving market conditions in the face of Fed rate hikes, officials may decide to speed up the pace of increases. “The concern is that financial conditions are quite easy and we are generating a sizable positive impulse to growth at a time when the economy seems to be at full employment and inflation is close to the Fed’s target,” Hatzius says.
Some members of the Fed’s rate-setting committee, such as Boston Fed President Eric Rosengren, are already making that case. He said in a March 29 Bloomberg TV interview that “we don’t want to grow so much faster than potential at this point” and suggested the situation warranted four rate increases in 2017.
Ultimately, the Fed will have to see whether the boost in the mood of the markets translates to an actual acceleration in consumption, Freedman says. “Stock markets go up. That in itself is not relevant,” he says. “What is relevant is its effect on people’s willingness to spend.”
The bottom line: If the Fed factored the stock market into its inflation debates, the current swings would argue for more rate hikes.
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