Monetary policy is tighter than it appears, but it may have peaked in July and started to ease according to our analysis of the Proxy Funds Rate, an analytical tool tracked and updated monthly by the Federal Reserve Bank of San Francisco. At the end of October, the rate was 6.7% compared with the official fed funds target of 5.25%-5.5%. It peaked at 7.1% in July and has declined through October. The rate recognizes that central bankers in the twenty first century use many tools (not just short-term interest rates) to meet their “dual mandate” of stable prices and maximum sustainable employment. The Fed uses forward guidance to communicate the direction of monetary policy and influence longer-term interest rates and broader financial conditions. The Fed also can expand its balance sheet through the large-scale purchase of Treasury and Mortgage Backed Securities, which is known as quantitative easing, or reduce its holdings, which is known as quantitative tightening. The Proxy Funds Rate uses the analysis of 12 financial variables, including Treasury rates, mortgage rates, and borrowing spreads, to translate the full range of policy actions into an analogous level of the funds rate, That can help assess whether policy is tighter or easier than the official funds rate suggests. In a November 2022 San Francisco Fed Economic Letter, the developers of the proxy rate noted the following: “As the FOMC increasingly used forward guidance and the balance sheet, the proxy rate has tended to lead the actual funds rate, reflecting the fact that financial markets are forward looking.” It could be a good sign for conventional Fed watchers if the proxy rate peaked in July. The letter also noted that “combined policy tools have a more complex effect on the economy than the federal funds rate indicates.” That suggests to us that Fed watchers should become even more diligent.
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