Tight but Loose

Is US monetary policy truly tight?

Key Points

·  Interest rates have increased quicker and further than most investors would have probably anticipated these past two years.  Although many expect interest rate policy to now evolve, leading to lower rates, when and by how much remains unclear.  Central banks want to be seen as being ‘hawkish’ on inflation, to counter the lingering perceptions that they missed the boat initially. However, is it right to believe that monetary policy is ‘tight’?

·  In the US, 10yr bond yields tend to track to, or be slightly ahead of, nominal GDP (= GDP + underlying inflation). In times of recession, we would expect nominal GDP to fall sharply.  But in more normal economic conditions, this relationship holds true usually.

·  Yet, as the chart shows, that relationship broke down after 2008, as central banks’ QE (quantitative easing) policies distorted bond markets, and the QE expansion that followed with COVID helped ‘smash it’. Now that QE has been replaced by QT (Quantitative Tightening) interest rates have risen.  Simply put, if the green line is above the black line, then policy would be tight, and below the line would be loose.

·  However, US nominal GDP remains robust, and even if lower inflation meant nominal GDP trending towards 5%, it’s still above current bond yields. The latest robust US GDP numbers suggest it looks unlikely that nominal GDP is set for a sharp fall in 2024, and early indications suggest the US economy is actually accelerating. So, for bond investors, while some may assume that monetary policy appears tight versus recent experience, a pre-2008 view of the world would make it seem rather loose.