Weekly asset allocation: is monetary policy affected by financial markets?
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In the 1980s, graduate students in economics learned that the “wealth effect” was minor at best. It is a behavioral theory that measures the impact of increasing wealth on consumption. In theory, when a household’s assets increase beyond its liabilities, its expenses should tend to increase. However, for much of the post-war period, the impact of asset prices was negligible. Consumption was much more sensitive to income. However, around 1995, the relationship between net worth and consumption increased significantly1.
The relationship between inflation-adjusted after-tax income and consumption is high, with a positive correlation of 69.6%. The graph to the right shows that from 1947 to 1995, the annual change in net worth and consumption was essentially uncorrelated; after 1995 until the end of 2019, the correlation jumped to 75.8%.
Why was net worth mostly unrelated to consumption and suddenly become so important? We suspect that the regulatory change that made it easier for homeowners to harness their home equity has played a role. We also suspect that lower capital gains tax rates have likely encouraged holders of financial assets to sell assets to finance consumption.
When net worth was independent of consumption, policymakers could generally ignore the impact of declines in financial markets.2. Although the Fed has a mandate to act as the lender of last resort, if most of the problems caused by financial stress were contained in the financial system, the FOMC could wait until it was clear that stress was becoming a risk. for the financial system itself. But, if a drop in net worth triggers a drop in consumption, the Fed’s full employment mandate requires it to cut rates to revive the economy. At the same time, making the rescue of the market a clear political objective incites moral hazard.
So, is the Fed changing its policy due to market conditions? We think it’s possible to argue that it does.
Above is a weekly chart of the target Federal Funds rate and the weekly VIX, smoothed with a 12-week moving average. We have placed a line at level 20 for the VIX. In the late 1990s, the FOMC raised the target rate despite the VIX consistently trading above 20. At the onset of the 2001 recession, the FOMC significantly lowered the federal funds target and cut back. continued to reduce until the smoothed VIX fell below 20. It only started to increase rates with the VIX comfortably below 20. Its easing cycle began before the onset of the recession in December 2007, just after the smoothed VIX rose above 20. The FOMC waited to raise rates after the smoothed VIX fell below 20, although it started cutting QE in 2013. When the first The rate hike began in December 2015, the smooth VIX jumped above 20, and the FOMC waited several months until it fell below 20 before resuming the tightening cycle. This tightening cycle ended after the smoothed VIX rose above 20. The easing cycle began in Q3 2019, with a VIX below 20, mainly due to an issue on the money markets. Of course, easing accelerated as the smoothed VIX skyrocketed due to the pandemic.
When will the FOMC increase its rates? If the history of the past two decades offers any insight, we would look for a smoothed VIX below 20 for a few months before policymakers raise rates. Why? Because the fall in the prices of household assets increases the risk of a decline in consumption and an increase in the probabilities of recession.
The relationship between the smoothed VIX and the federal funds target suggests that the FOMC takes stock market activity into account when setting the policy rate. While this behavior does not exactly mean that the Fed is targeting the stock market, it does pay attention to the stability of financial markets. Thus, the trajectory of policy tightening will, at least in part, be linked to stock market volatility.
1 On the consumption graphs, the left graph shows the annual evolution. The graph on the right shows the annual changes with net worth increasing by a quarter after 1995. The correlations in both graphs exclude the pandemic, which skews the relationship in both cases.
2 Real estate assets matter too, but since house prices rarely fall (of course, the exception was after 2005), declines in financial markets are more relevant.
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