The recent cooling of the U.S. economy: Tariffs or Fed tightening?

The recent cooling of the U.S. economy has sparked a debate, with some commentators pointing to trade tensions and tariffs as the primary culprits. While it is true that tariffs can disrupt supply chains and raise costs, their impact on an economy the size of the United States is often overstated. Instead of focusing on external factors, a more accurate assessment of the current economic slowdown requires a look at domestic monetary policy. The Federal Reserve, by raising its federal funds rate and keeping it elevated for an extended period, has directly engineered a slowdown in economic activity. This policy tightens financial conditions, making it more expensive for businesses to borrow and invest and for consumers to purchase big-ticket items like homes and cars.

History provides a powerful precedent for this economic dynamic. In the early 1980s, under the leadership of then-Fed Chair Paul Volcker, the central bank aggressively hiked interest rates to combat rampant inflation. The federal funds rate soared to a staggering 20%, a move that successfully crushed inflation but also intentionally triggered a severe recession (see figure below: Fed Funds Effective Rate - Gross Domestic Product). This historical episode serves as a clear example of the Fed's immense power to slow down the economy through monetary policy. The current situation mirrors this playbook, albeit on a less dramatic scale, as the Fed's actions have systematically removed liquidity from the financial system and reduced demand.

To see this cause-and-effect relationship in action, one only needs to look at the data. A review of historical economic trends reveals a strong correlation between the federal funds rate and overall economic growth, as measured by GDP. The periods following sustained rate hikes often coincide with periods of economic contraction or slower growth. The data clearly shows that the real force at play in the current economic environment is not trade policy, but the deliberate and often-overlooked decisions of the central bank. For a brief discussion on this, along with a few other related topics, please refer to the video linked below.

The Fed's long reach: Influencing the 10-year Treasury

The 10-year U.S. Treasury yield serves as a linchpin for numerous borrowing rates across the economy, making it a crucial determinant of both consumer and business spending. Its influence extends to mortgage rates, corporate bond yields, and even the cost of auto loans. When the 10-year yield rises, it generally signals tighter financial conditions, leading to higher borrowing costs and potentially dampening investment and consumption. Conversely, a fall in this benchmark yield can ease financial constraints, encouraging borrowing and stimulating economic activity. This pervasive impact underscores the significance of the 10-year Treasury in shaping the overall economic landscape.

A commonly held belief within financial circles is that the Federal Reserve's monetary policy tools are primarily effective in controlling short-term interest rates, most notably the federal funds rate. The traditional view suggests that while the Fed can directly dictate the cost of overnight borrowing between banks, its influence over longer-term yields, like the 10-year Treasury, is largely indirect, mediated through market expectations of future short-term rates and inflation. This perspective often portrays the long end of the yield curve as being more subject to the ebb and flow of market sentiment and long-run economic forecasts, with the Fed's direct control seen as limited.

However, the Federal Reserve's response to the Global Financial Crisis provides a compelling historical example of its capacity to directly influence 10-year U.S. Treasury yields. In the years following the crisis, the Fed implemented multiple rounds of quantitative easing (QE), involving the large-scale purchase of long-term Treasury bonds and mortgage-backed securities. These actions directly increased demand for these assets, putting downward pressure on their yields, including the 10-year Treasury. For instance, during QE2 (November 2010 - June 2011), the Fed explicitly aimed to lower longer-term interest rates to support the economic recovery (see figure above). The subsequent decline in the 10-year Treasury yield during this period demonstrates the Fed's ability to actively shape the long end of the yield curve through targeted interventions. For a brief discussion on this, along with a few other related topics, please refer to the video linked below.

How much do long Treasuries increase with each 1% decrease in the 10-year Treasury yield?

The figure below shows five values of the TLT exchange-traded fund, which tracks the value of Treasury bonds with maturities of 20 years or more (i.e., long Treasuries), and of the corresponding 10-year Treasury yields. The latter, 10-year Treasury yields, are highly correlated, in a lagged way, with the Federal Funds rate. This rate is set by the Fed.

As you can see from the best fitting line equation, there is an increase of approximately 19 points in the value of the TLT for each 1% decrease in the 10-year Treasury yields. So, if the Federal Funds rate us expected to go down, the gain likely to be obtained by investing in long Treasuries in quite attractive. The video linked below provides a brief discussion on this a few other related issues.

Fed funds rates, 10-year Treasury rates, and recessions