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The Fed makes it look easy
admin | December 18, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
With the onset of the pandemic early this year came a severe tightening of financial conditions as liquidity dried up and investors sold risky assets. The Fed responded with an unprecedented series of measures intended to restore market functioning and support the economy by creating easier financial conditions. The Fed’s efforts succeeded. As the year draws to a close, financial conditions are essentially back to where they began the year and likely to get even easier in 2021.
Chicago Fed Financial Conditions Index
The Chicago Fed National Financial Conditions Index (NFCI) is one of many measures of financial conditions, but it is a far more inclusive measure than most. It includes a total of 105 indicators classified into three broad types: risk, credit, and leverage. It is not as real-time as some of the alternatives, as some of its components are not market prices and thus may be released only monthly or even quarterly. For example, several gauges from the Fed’s Senior Loan Officer Survey are in the index. But the comprehensiveness of the index offers a broad and accurate look at financial conditions.
The pandemic and the Fed response
The Chicago Fed NFCI has a long history. The index is set so that zero corresponds to the long-term average of financial conditions while 1.0 is one standard deviation tighter than average and -1.0 is one standard deviation easier than average. A range of +1.0 to -1.0 covers almost the entire range of conditions seen over the past 30 years, with the notable exceptions of the tightest readings during the 2008-2009 Great Financial Crisis (Exhibit 1).
The swing in financial conditions in early 2020 marked a tightening rarely seen in recent decades. The index began the year at about -0.6 but moved all the way to +0.3 in late March and early April, a swing of almost a full standard deviation.
Exhibit 1: Chicago Fed National Financial Conditions Index
Source: Chicago Fed.
The Fed responded forcefully to support the economy. Initially the FOMC slashed the fed funds rate to the zero bound and offered a variety of programs to bolster liquidity, especially for money markets. Then it ramped up its Treasury and agency MBS purchases, buying as much in a single day as it purchased in a month during the rounds of QE seen in the prior cycle and sustaining that pace for weeks.
Then the Fed became even more creative, with the support of the Treasury Department and ultimately Congress. It created various lending facilities to boost liquidity in the corporate bond market, the muni market, the ABS market, and even offered to lend directly to medium-sized businesses via the Main Street Facilities.
Success
Not all of these programs ended up being used to a substantial degree, but they were broadly successful in restoring the confidence of financial market participants and thus reversing the tightening of financial conditions. A closer look at the index in 2020 shows that the Fed managed to reverse over half of the tightening in financial conditions within two to three months (Exhibit 2). Moreover, conditions have continued to ease through the remainder of the year, and the index currently sits at -0.62, signifying marginally easier conditions than prevailed at the end of 2019 (-0.58).
Exhibit 2: Chicago Fed National Financial Conditions Index: a 2020 close-up
Source: Chicago Fed.
The Fed’s efforts did not go entirely as policymakers had hoped. For example, the Main Street Lending Facility failed to attract much interest. Nonetheless, the broad attempt to engineer easy financial conditions to support an economy that needed all the help it could get clearly worked. With the Fed promising to maintain its easy monetary policy, including asset purchases, until “substantial further progress” has been made toward its dual mandate objectives, there is good reason to expect financial conditions to continue to ease next year.
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