Why is the economy still booming despite monetary policy tightening?

In the current global economic situation, the monetary policy of the Federal Reserve has received unprecedented attention. Despite the policy interest rates reaching historic highs, the U.S. economy remains strong, a phenomenon that seems to defy the expectations of traditional economic theory. The sustained hot job market and steady economic growth inevitably raise the question: why has the tightening monetary policy failed to effectively curb economic overheating as it has in the past? The latest research indicates that the phenomenon is not a paradox, but rather a limitation of traditional analytical frameworks. By reexamining the impact of financial conditions on the economy, we can gain a deeper understanding of the actual transmission mechanism of monetary policy.
The Federal Reserve has raised interest rates to historic levels, but the economy continues to grow. The current strong employment report is proof of this. Why is this happening?
According to our latest paper, it may be because we are focusing on the wrong indicators.
Although the policy interest rate is high, the financial environment is actually quite loose. The stock market rise and the tightening of credit spreads effectively offset most of the Fed's tightening policies.
Data shows that the FCI-G index, designed by the Federal Reserve to measure its impact on economic growth, confirms this. Despite rising long-term interest rates and a stronger dollar, the positive performance of the market, mainly the prosperity of the stock market and the improvement of credit spreads, is stimulating economic growth.
Tight monetary policy and strong growth are not actually a paradox.
Our research with Ricardo Caballero and @TCaravello shows that what matters to the economy is not just the policy interest rate itself, but the broader financial conditions.
Our analysis suggests that even when the financial environment is relaxed, the output and inflation will be stimulated, and ultimately force interest rates to rise, even if driven by noisy asset demand (emotion). This is consistent with what we are seeing today.
From a quantitative perspective, research has found that the impact of financial conditions on economic output fluctuations accounts for as much as 55%.
In addition, the main transmission mechanism of monetary policy should be through affecting the financial conditions, rather than directly through interest rates.
The current situation fits into this framework: despite high interest rates, loose financial conditions are supporting strong growth and may prevent inflation from returning to target levels.
Looking ahead, this indicates that the Fed's mission is not yet complete. To achieve the 2% target, the financial environment may need to tighten.
This may be achieved through the following ways: market adjustment - strengthening of the US dollar - further interest rate hikes.
The interest rate path will mainly depend on market dynamics. If the market adjusts and the US dollar strengthens, the current level of interest rates may be sufficient. However, if the financial environment remains accommodative, further rate hikes may be necessary.
This framework suggests that Fed watchers should pay less attention to the debate over 'terminal rates' and more attention to the evolution of financial conditions. This is where the real transmission of monetary policy occurs.
While our paper goes further by proposing specific FCI objectives, what's more important is that we need to change the way we think and talk about monetary policy. The policy rate is only an input, financial conditions are what really matter.

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