We are at an intricate monetary turning-point. Dollar overnight rates have been driven up by more than 5 percentage points in two years. US inflation is down, but has ticked upward, and is still well above the Fed’s formal target of 2 percent. Markets think rates should come down; the Fed prizes market quiescence, but not as much as it prizes its own credibility.
The discourse on monetary policy is noisy. I can’t fix that unilaterally, but let me offer an observation: high interest rates do not necessarily mean that money is tight. I’ll go even further and say that right now, there are multiple reasons to think that money is not tight, and in fact that monetary conditions are still rather loose.
When is money tight?
When is money tight? Or in more sophisticated terms, when do monetary conditions restrain economic activity? It is common, both in academic discourse and in the financial press, to equate high interest rates with tight money. The argument, based on supply and demand, is familiar enough to seem intuitive: high interest rates mean borrowing is more expensive. This is thought to reduce demand for borrowing. Money is tight because rates are high.
Only modest reflection is needed to destabilize this intuition. The central objection is that people borrow in order to invest, and so the relevant consideration is not the cost of borrowing, but rather the difference between the cost of borrowing and the expected yield on the investment. If you can convince yourself that you can earn 7% yield, borrowing at 5% still seems cheap. The US is booming right now, evidenced by this week’s bumper retail sales figure for March, and headline unemployment still below 4%. Under such conditions, it is easy to rationalize high expected yields on investment. The technological novelty of large language models, for example, serves up such rationalizations on the daily.
Investment yields are analogous to interest income—the fixed interest income paid to a bond investor has much in common with the variable dividend income paid to an equity holder. More precisely, interest is not only an expense. It is an expense for borrowers, and ipso facto it is income for lenders and investors. High interest rates make life harder for some, but easier for others. So it need not be automatic that higher rates restrain economic activity, IS—LM very much notwithstanding.
The money markets provide what I think is the cleanest and highest-frequency way to measure this asymmetry. Below is a graph of daily dollar overnight interest rates. Rates are measured not as levels, but as spreads above the rate paid at the Fed’s overnight reverse repo (ON RRP) deposit facility. The upper and lower bounds on the fed funds rate, the rate paid on bank reserves, and the ON RRP rate itself are policy rates, thus straight lines; the other rates are market rates that fluctuate daily. The logic of this presentation is that holders of money can always get the ON RRP rate by depositing at the Fed, so under normal conditions they should never accept rates below that floor. To interpret the graph, one need not dwell on the precise readings of each rate; just look at where the whole complex of rates sits relative to zero. With that in mind, the graph tells a compelling story:
In 2020 and 2021, the Fed flooded the financial system with newly created reserves, the liability counterpart to its almost $5 trillion in asset purchases. Overnight rates were driven down toward the ON RRP rate floor, and some rates frequently leaked below the floor, mostly in 2022. In other words, money was loose, so loose that plenty of lenders would accept less interest than what the Fed was paying. Since 2023, the overnight rate complex has drifted back up, mostly off the floor and much more rarely below it. This is connected to the increases in interest rates, marked by vertical lines in the graph. But it is not identical to those increases—rates have jumped up while spreads have drifted, mostly up but not only up.
And now?
And now? Viewed through overnight rates, money is certainly tighter than in 2023. But some of these rates still print at or below ON RRP with some frequency, and have only occasionally tested the upper half of the Fed’s range. Market power, by this measure, still lies more on the side of borrowers than on that of lenders.
What does this mean for the Fed and for Fed-watchers? The US central bank’s problem is that its main instrument, the fed funds rate, does not exert a direct influence on its main policy target, PCE inflation. The connection is weak, and other factors can intervene. And as the graph above shows, higher rates do not make money tighter if lenders are still fighting to lend.
Fed-watchers would do better, in my opinion, to focus on balance-sheet contraction, the Fed’s ongoing process of allowing its asset portfolio to run off. This has taken a lot of money off the table, and sooner or later will lead lenders to tighten their fists.