The Federal Reserve has been testing out a new playbook for monetary policy this year that’s helping officials understand how Brexit-inspired shock waves across financial markets will affect the U.S. economy.

Their innovation, which incorporates the biggest lesson they learned in the financial crisis, may sound like common sense: Monetary policy needs to respond to investor anxiety triggered by events such as China’s currency devaluation and the U.K. vote to leave the European Union. That’s because market instability can have important economic effects which were previously under-appreciated.

Recent work by Fed researchers has elevated these financial shocks to an equal footing with the traditional textbook drivers of business cycles -- like interest rates, government spending and oil-price swings -- and only in the last few years have they been explicitly incorporated into the models the central bank uses to forecast growth.

That helps to explain why Fed Chair Janet Yellen has been so reluctant to raise rates a second time after a hike in December, and why policy may be sidelined for months to come. A pullback in lending actually offsets the stimulus the Fed is trying to keep in place by holding $4.5 trillion of assets on its balance sheet.

“It’s just become a much more prominent way of looking at the world,” said Simon Gilchrist, a Boston University professor whose work with Fed economists on the topic has been influential. “Part of it is that we just measure this stuff much better now than we used to, and it’s easier to then see the linkages between financial conditions, uncertainty and the real economy.”

Fed staff, already puzzling over the economic impact of market moves late last year and earlier this year that added up to the biggest financial shock since 2008, will now also have to weigh the likely effects of volatility spurred by the U.K. vote.

The dollar strengthened, stocks fell and the yield on 10-year U.S. Treasury notes declined to just shy of a record low as investors ran into safe assets while shedding risk. They now see additional Fed tightening as off the table for at least another year, according to the prices of options on eurodollar futures contracts.

Answering questions after a speech in Chicago on Tuesday evening, Fed Governor Jerome Powell said the market reaction to the U.K. vote amounted to “a modest tightening of financial conditions,” adding that “financial conditions have tightened significantly, the equivalent of several rate hikes, since 2014.”

Until now, the central bank’s rate-setting Federal Open Market Committee has been split between those who see its monetary policy goals of stable prices and full employment as nearly met and those who are in risk-management mode, according to Laurence Meyer, a former Fed governor who now works at a Washington-based policy analysis firm that bears his name.

“The latter group puts a higher weight on being super-cautious given the asymmetric risks at the zero bound,” he said. “That argument just got a little weightier and that group just got wider.”

Fed officials including Yellen have argued that policy has less scope to respond to weaker growth -- because rates are still near zero -- than to an overheating economy, in which case they would have plenty of room to raise rates.

Gilchrist and his co-authors have developed a measure that attempts to capture the component of corporate borrowing costs influenced by investors’ risk preferences -- a gauge they believe can impact the economy on its own, as opposed to merely offering a reflection of conditions. It surged at the end of 2015 and beginning of 2016 to the highest level since the financial crisis as turmoil gripped financial markets.
Hurting Growth

New York Fed researchers estimated that the rapid rise in credit spreads over that period -- which they attribute to reductions in the outlook for international economic growth and deteriorating creditworthiness of companies in the U.S. energy sector -- subtracted more than one percentage point from U.S. growth on an annualized basis in each of the third and fourth quarters of 2015 as well as the first quarter of 2016.

Actions taken by Fed officials in the first quarter to reduce investors’ expectations for the path of the central bank’s benchmark rate managed to roughly offset the shock, according to the model.

Yellen and several others on the central bank’s 17-member FOMC have embraced this narrative. Policy makers considered to be especially cautious, such as Fed Governor Lael Brainard and Chicago Fed President Charles Evans, have gone a step further, warning recently that the improvement in financial conditions since earlier this year could be undone if Fed officials were to begin projecting a faster pace of rate increases.

A key question prior to the U.K. vote was to what extent weaker U.S. employment data are a result of the financial shock. American employers added only 123,000 workers in April and 38,000 in May after hiring close to 200,000 per month on average in the first quarter, according to figures published by the Labor Department on June 3.

“I believe strongly that the financial turmoil of January and February had an effect,” Dallas Fed President Robert Kaplan told reporters on June 23 after a speech in New York. “Time will tell how much of an effect it had, and what other factors are going on here.”

Going forward, policy makers will monitor corporate borrowing costs for any sign that U.S. companies are once again having a difficult time obtaining funding in the aftermath of Britain’s leave vote.

The heightened focus on financial conditions in part reflects the dangers of a low-growth, low-interest rate environment, in which relatively small disturbances have become more important, said Roberto Perli, a partner at Cornerstone Macro LLC in Washington.

“If you have financial conditions tighten a lot, they could do a lot more damage” in this economy compared to one growing at a faster rate, said Perli, a former Fed economist. “Your margin for error is a lot smaller.”