(Originally published here.)
Nobody really knows how monetary policy works, which is something to keep in mind while reading commentary about the jump in interest rates and the decline in stock prices right after yesterday’s statement and news conference by the Federal Reserve. Many have interpreted the moves as a sign that the Fed is heading in ahawkish direction. More than anything, the market reaction simply reflects heightened doubt about the Fed’s next moves.
Every measure of interest rates has gone up since yesterday afternoon but the biggest moves have occurred in the two- to five-year range, which traders call the belly of the yield curve. These interest rates are most sensitive to changing expectations of Fed policy and the economic outlook, so it’s telling that those were the ones that jumped the most. The yield on five-year U.S. Treasury inflation-protected securities has increased by almost 0.3 percentage point so far and is still rising as of this writing.
Agonizing over these market moves is probably a waste of time. Higher interest rates make new debt more expensive to service, but if borrowers can raise more than before and do so on looser terms it isn’t really fair to say that financial conditions have tightened. Besides, yields on government debt usually just track the annual change in nominal gross domestic product.
What really matters for the private sector is the cost of borrowing relative to expected income growth. Most people would rather pay 5 percent on their mortgage when they expect to get a raise of 4 percent every year than have a mortgage with a 3 percent rate while getting a raise of just 1 percent, for example. In fact, the difference between the yields on junk bonds and the interest rates paid by the government suggest that financial conditions are actually quite loose.
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