Written by: Alp Simsek, Professor of Finance, Yale School of Management; Compiled by: Tia, Techub News

Editor's Note:

In Under the current global economic situation, the Federal Reserve's currency has received unprecedented attention. Although interest rates have risen to historic highs, the U.S. economy remains strong, a phenomenon that appears to defy the expectations of conventional economic theory. The continued hotness of the job market and the steady growth of the economy make people ask: Why has tight money failed to curb economic overheating as effectively as before? The latest research points out that behind this phenomenon is not a paradox, but the limitations 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 money.

The Federal Reserve has raised interest rates to historical levels, but the economy is still on the rise. The current strong jobs report is proof of that. Why does this happen?

According to our latest paper, maybe it's because we're focusing on the wrong metrics.

Although interest rates are high, financial conditions are actually quite loose. Rising stocks and tighter credit spreads effectively offset much of the Fed's tightening.

The Fed’s own FCI-G index, an index that combines financial variables to measure their impact on economic growth, confirms this, data shows. While long-term interest rates are rising and the U.S. dollar is strengthening, positive market performance, primarily a boom in equity markets and improving credit spreads, is stimulating economic growth.

Tight money and strong growth are not actually a paradox.

In our research with Ricardo Caballero and @TCaravello we show that what matters to the economy is not interest rates per se but broader financial conditions.

Our analysis shows that when financial conditions ease, even when driven by noisy asset demand (sentiment), it stimulates output and inflation, ultimately forcing interest rates higher. This is consistent with what we are seeing today.

From a quantitative perspective, the study found that financial conditions account for up to 55% of the fluctuations in economic output.

In addition, the main transmission method of money should be to affect financial conditions, rather than acting directly through interest rates.

The current situation fits this framework: despite higher interest rates, easy financial conditions are supporting strong growth and may prevent inflation from returning to target.

Looking ahead, this suggests the Fed's work is not yet done. To achieve the 2% target, financial conditions may need to tighten.

This could happen through: market correction - dollar strength - further interest rate hikes.

The path of interest rates will largely depend on market dynamics. If markets correct and the dollar strengthens, current interest rate levels may be sufficient. But if financial conditions remain accommodative, it may be necessary tofurther interest rate hikes.

This framework suggests that Fed watchers should focus less on the "terminal rate" debate and more on the evolution of financial conditions. This is where the real monetary transmission occurs.

While our paper goes one step further by proposing clear FCI goals, more importantly we need to change the way we think and talk about money. Interest rates are only one input, financial conditions are what really matters.