The Economy Has Slowed Because the Fed Has Already Tightened

The U.S. economy has downshifted rather abruptly in the last few months, promptingnew discussion within the Federal Reserve about delaying its first interest-rate increase. Yet the growth deceleration should not come as a surprise, because the Fed has already tightened.

True, the Fed’s interest-rate target remains close to zero. But the Fed tightens through its words, not just its actions, and the drumbeat of chatter from the Fed in the last year has made it clear that officials plan to start raising rates sometime this year.

That chatter has made itself felt in stock, bond, and most important foreign exchange markets. The dollar’s sharp rise in the last six months is not due not just to theEuropean Central Bank’s dramatic easing of monetary policy through quantitative easing (QE, the purchase of bonds with newly created money), but to the juxtaposition of the ECB’s action against anticipation that the Fed will soon tighten.

Anticipation of tighter U.S. monetary policy also shows up in various measures of risk such as the spread between yields on corporate bonds and safe Treasurys, which have widened, or the stock market, which has stopped climbing.

These are captured nicely in an index of financial conditions compiled by Goldman Sachs. The index has risen sharply since last August, by enough to imply a 0.75 percentage point slowing in economic growth this year.

That does not fully explain the first quarter slowdown, because there has also been a big drop in the price of oil. When Goldman adds the oil price to its index, there hasn’t been a tightening in financial conditions. Usually, the boost from cheaper oil kicks in before the drag of a higher dollar. This time around, Goldman’s Chris Mischaikow says, the reverse seems to be true: So far, the usual beneficiaries of lower oil prices have not shown much response. (The fall in oil prices has also driven up yields on oil companies’ bonds — one reason corporate spreads have widened.)

This is a reminder of something investors and Fed officials routinely forget: Markets discount the Fed’s actions long before they actually occur, in ways that are not obvious at the time. We saw that with the 2013 “taper tantrum” that sent mortgage rates up sharply and soon produced a notable slowing in housing and other interest-sensitive parts of economic growth.

The Fed should therefore respond to this in one of two ways. First, the tightening in financial conditions has already done much of the work that its first interest-rate increase was supposed to accomplish. This is a good reason to either delay the start of tightening, tighten more slowly, or both.

Second, if Fed officials feel the tightening in financial conditions is excessive, they should change how they talk. The dovish message of the March Fed meeting arrested the rise in the dollar, and more officials are expressing concern about the tone of recent data.

This has already caused Goldman’s index to level off. If it stays level, the flattening in in economic growth should soon pass.

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