Financial conditions have already tightened significantly, starting even before the U.S. central bank began raising interest rates last March to fight 40-year-high inflation, as investors anticipated the Fed’s actions.
Assuming the Fed follows through on its projections from December for the policy rate to go to 5.1% by May and for inflation to fall to 3.1% by then, the Fed will have delivered the sharpest round of policy tightening on record, the San Francisco Fed researchers wrote.
Though stock prices historically tend to rise at the tail end of Fed policy tightening cycles, this time may be different, according to the analysis from San Francisco Fed senior research advisor Simon Kwan and research associate Louis Liu.
Based on how asset prices have behaved in prior tightening cycles, they wrote, “stock prices are projected to decline further” along with “more tightening in the bond market.” That is in large part because of how easy policy was at the starting point of this cycle, with the Fed funds rate near zero even as inflation was rising, producing a historically large negative “real rate gap.”
“While the rapid tightening of financial conditions is expected to slow the economy relatively quickly, historical experiences raise the possibility of even more tightening in financial conditions given the large real rate gap that needs to be closed,” they wrote.
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