The Fed didn't tighten today

The Fed increased its target short-term interest rate today to 0.75%, but that doesn't represent a tightening of monetary policy. It would be more correct to say that today monetary policy became slightly less accommodative. Neither the market nor the economy has anything to fear from today's Fed action. Financial markets today enjoy plentiful liquidity conditions, and confidence in general in rising.  Interest rates have adjusted upwards slightly to reflect this. Remember: higher interest rates don't threaten growth; interest rates are higher because growth expectations are somewhat stronger. This is all good news. Today's modest decline in equity prices is more a buying opportunity than a warning sign.

The chart above compares the current real short-term rate (red) with the market's expectation for what the average real short-term rate will be over the next 5 years (blue). The current real short-term rate is about -1%, and that rate is expected to average about zero over the next 5 years. There is no way this represents a tightening of monetary policy for the foreseeable future. And since the real yield curve is still positively sloped (i.e., the blue line is higher than the red line), that is yet another indication that monetary policy is not tight, nor is it even beginning to get tight. The time to worry is when the red line approaches and exceeds the blue line (as happened prior to the past two recessions), because that is the market's way of saying the Fed is tight enough to threaten growth.



The chart above shows that the prices of gold and 5-yr TIPS continue to track each other (using the inverse of the real yield on TIPS as a proxy for their price). This is significant, because it says that the market is willing to pay less for the protection of TIPS and gold, and that in turn is equivalent to saying that the market is regaining confidence in the future. Gold is still quite expensive (my calculations say that the long-term average price of gold in today's dollars is somewhere in the neighborhood of $500-600 per ounce), and real yields are still very low, so it's still the case that the market is on the defensive, and risk aversion is still evident.

Swap spreads are almost exactly at a level which is "normal." That means that liquidity conditions are very healthy, and it further suggests that the outlook for growth is also healthy. No one is being starved of liquidity as a result of the Fed's "tightening" of monetary policy. In the past, prior to IOER, the Fed tightened by reducing the availability of bank reserves, which tends to shrink the amount of money in the financial system. But that is not the case today. All the Fed has done is to change the appeal of holding cash equivalents—by making them somewhat more attractive on the margin. That is a prudent move, because the recent rise in the equity market tells us that the market is becoming more optimistic on the margin about the future, and more optimism would imply less demand for cash equivalents. The Fed needs to respond to rising optimism by making bank reserves more attractive; otherwise banks might be tempted to lend too much, and that could give us higher-than-expected inflation.

As the chart above shows, credit spreads are still relatively low. That's another way of saying that the Fed's move today presents no threat to economic growth. Markets are comfortable with the Fed's move, and generally agree with the Fed's assessment that the economic outlook has improved somewhat and that higher real rates are justified.