The Big Idea

Defying the odds and the Fed

| December 8, 2023

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.

The Federal Reserve over the past 18 months has tightened policy to bring inflation under control. For much of that time, financial markets have resisted Fed guidance on future rate hikes. In November, investors collectively determined that the Fed will probably begin to ease by early 2024, leading to a sizable drop in Treasury yields and a tightening of spreads on risk assets.  As a result, financial conditions have become much easier, working against the Fed’s attempt to implement restrictive policy. All else equal, the easier conditions will presumably delay any pivot to rate cuts in 2024.

Financial conditions and Fed policy

Fed officials have long noted that monetary policy is transmitted to the economy in large part through financial conditions.  Not many households or businesses borrow at the fed funds rate, the vehicle that the Fed uses as its main policy instrument, so the stance of monetary policy depends on how markets translate a given Fed setting into broader financial conditions.

This relationship came into sharper focus in October.  The September FOMC meeting brought what were viewed as hawkish “dot” projections of monetary policy, and investors finally bought into a message that the Fed had been delivering for months on end: that policy would remain restrictive for quite some time.  Treasury bonds and the equity market sold off hard.  Suddenly, in response, Fed officials in October began to publicly express nervousness that financial conditions had tightened enough to do the Fed’s work for it.  At that point, policymakers began to back away from the additional rate hike that just a few weeks ago the dot projections had indicated was expected by a solid majority of the FOMC.

At the time, I was highly critical of this line of reasoning by Fed officials.  I noted that financial conditions often swing wildly for a time without necessarily having a lasting impact on the economy, and I indicated that the Fed’s logic was circular, since its newfound dovishness would likely lead to a swing toward easier financial conditions.  I suggested that a number of Fed officials might be turning to tighter financial conditions as an excuse not to tighten.  I argued that Fed officials seemed to want to be done, and that the snugging of financial conditions offered a convenient rationale for backing off of further rate hikes at a time in   the most recent economic data were red-hot, which seemed to justify an additional rate increase or morefrom the Fed.

The circular nature of the Fed’s argument became clear far more quickly and more forcefully than most expected.  As soon as investors concluded that the Fed had lost its appetite for further rate hikes, Treasuries and risk markets both posted historic rallies in November, reversing the entire swing that had created such an abrupt shift in Fed rhetoric just the month before.

Financial conditions indices

There are a number of different ways to measure financial conditions.  Two of the favorites of financial market participants are the Bloomberg and Goldman Sachs financial conditions indices.  Both are relatively simple indices that consist of market indicators and are updated daily.  The Bloomberg index includes a few money market spreads, several bond spreads, and, for equities, the S&P 500 and the VIX.  The Goldman index, meanwhile, is a weighted average of short-term and long-term interest rates, the trade-weighted dollar, credit spreads and a P/E ratio for stocks.

The Goldman Sachs index is now at roughly its easiest setting in four months—up is tight, and down is easy (Exhibit 1).  Meanwhile, the Bloomberg index is about as easy as it has been since February 2022, before the Fed began to hike rates—for the Bloomberg gauge, up is easier and down is tighter (Exhibit 2).

Exhibit 1: Goldman Sachs U.S. Financial Conditions Index

Source: Goldman Sachs, Bloomberg.

Exhibit 2: Bloomberg Financial Conditions Index

Source: Bloomberg.

Chair Powell and other Fed officials have repeatedly noted when they discuss the topic that they like to take a broad view of financial conditions, spanning more than just a single indicator like 10-year Treasury yields or stock prices.  A financial conditions index that closely replicates that approach is the Chicago Fed National Financial Conditions Index. This composite casts a far wider net, including 105 measures of financial activity.  In addition to a large number of market-based prices and spreads, this index includes many other variables, such as responses from the Federal Reserve Board’s Senior Loan Officer Survey, the NFIB small business survey, and the University of Michigan survey of consumers.  As a result, unlike the other two measures, this index does not update daily.  Rather, it is calculated weekly with revisions, and a number of the components are reported even less frequently—at the extreme, the Senior Loan Officer survey is conducted only once a quarter.

In any case, the Chicago Fed National Financial Conditions Index, where up is tighter and down is looser, shows financial conditions are by far their easiest since February 2022, before the Fed began to raise rates (Exhibit 3).  For what it is worth, it also illustrates that the tightening that Fed officials were harping on in October turned out, in retrospect, to be trivial.

Exhibit 3: Chicago Fed National Financial Conditions Index

Source: Chicago Fed.

Implications for 2024

In reality, financial conditions are just one of many inputs that go into Federal

Reserve decision-making.  Nonetheless, the circular nature of the interaction between financial conditions and Fed policy also applies looking ahead to 2024.  The more that financial market participants price in aggressive rate cuts for next year, the looser financial conditions will be.  All else equal, the more easing investors price in, the less likely the Fed is to actually cut rates.  To be fair, all is rarely “equal.”  One could imagine a scenario where financial conditions are growing looser because the markets expect the economy to soften sharply and Fed easing to ensue.  Alternatively, financial conditions could grow easier if investors look for the economy to perform well, driving a heightened appetite for risk.  At the moment, it appears that these two seemingly mutually exclusive scenarios are both being priced in, as Treasuries and stocks and risk markets broadly rallied simultaneously in November.

The prevailing wisdom appears to be that the economy will hold up well enough to sustain the value of risky assets, but that inflation will still quickly decelerate toward 2%, driving the FOMC to cut rates earlier and more forcefully than policymakers have been signaling.  I have seen this scenario referred to as the “Immaculate Disinflation.”  Such an outcome flies in the face of what Fed officials have said—that a sustained return of inflation to the 2% target will require a period of below-trend economic growth and a cooling of labor market pressures.

It will be interesting to see whether Fed officials take a symmetric view toward financial conditions.  The consistent mirror image of October’s episode would dictate that Chair Powell and the Committee cite looser financial conditions as a reason to stay restrictive for longer—or, in the extreme, to hike rates further, though I assume, as do most economists, that the Fed has already decided not to tighten again unless inflation reaccelerates.  If Powell makes that case forcefully next week, then financial conditions could, in theory, swing violently for a third time since September.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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