The Big Idea

A critical economic tailwind

| March 15, 2024

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 policy rate has been above 4.00% since late 2022 and at 5.375% since last July, a significantly restrictive level. The economy nonetheless has shown great staying power, expanding by over 3% in real terms last year and off to a healthy start in 2024. One of the key reasons that Fed efforts to cool economic activity has failed to match expectations is that financial conditions broadly are much easier than the fed funds rate alone would suggest, as investors have combined a dovish policy outlook with an embrace of risk markets. This ebullience likely reflects, at least in part, the extremely generous provision of liquidity emanating from the Fed’s still massive balance sheet.

Tolerance for high rates

At the beginning of 2022, before the Fed had lifted the policy rate off of the zero bound, there was a broad consensus in the financial community, based on the experience in the years between the financial crisis and the pandemic, that the economy would be unable to handle anything more than a modest increase in interest rates.  In fact, at that time, fed funds and SOFR futures indicated that investors expected the peak of the hiking cycle would be below 2%.  The sentiment then was that anything more would tank the economy and send a vulnerable federal government fiscal situation into crisis.

As it turns out, inflation proved far more persistent than Fed officials had hoped, and the FOMC was forced to hike rates more forcefully, eventually taking the funds rate target in excess of 5%.  The current target range is the highest since early 2001.

Fed officials were clear that they were prepared to do whatever it took to bring inflation back under control, even cause a recession.  Thankfully, however, the economy has proven far more resilient than anyone imagined over the past two years.  While the inflation war is not yet won, it appears increasingly likely that the FOMC may be able to pull off the historically rare soft landing, engineering a return to low inflation without sparking an economic downturn.

There are several possible explanations for why has the economy proved so bulletproof in the face of restrictive policy. The residual ripple effects of an unprecedently stimulative fiscal policy during the pandemic undoubtedly helped to sustain economic growth long after the largest emergency programs were ended.  In fact, government spending even now is likely providing a noticeable boost to growth, as packages like the 2021 infrastructure bill and the 2022 CHIPS Act fund construction projects throughout the country.

Another source of stimulus for the economy likely comes from the Fed’s balance sheet.  The Fed more than doubled the assets on its balance sheet from 2020 through early 2022, when it finally ended QE, injecting almost $5 trillion of liquidity into the financial system and ultimately the economy. The Fed’s balance sheet reduction, which has been in place for almost two years now, has drained about $1.5 trillion. However, in my view, there is still at least $1 trillion in excess liquidity (and possibly noticeably more) sloshing around in the financial system.  Some of these funds are parked in safe, short-term assets like Treasury bills, but the favorable broader investment atmosphere likely also reflects the plentiful liquidity available in the financial system.  Stock indices have been repeatedly making new highs in recent days, and all sorts of risk spreads in the fixed income universe are historically low.

Financial conditions indices

The contrast between a clearly restrictive policy rate setting and favorable broad financial conditions can be quantified in a number of different ways.  Financial conditions indices offer insight on how this contrast nets out.  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.

Based on the Goldman index, financial conditions were historically easy in early 2022, when the FOMC was still conducting QE and before it began raising rates (Exhibit 1).  The index at 100 is neutral, up is tight, and down is easy. This gauge tightened considerably in 2022, leveled off for much of 2023, tightened significantly last fall, and then began easing again when Fed officials started to complain about the more restrictive financial conditions. Though fed funds expectations have swung up and down wildly in recent months, the GS Financial Conditions index has steadily eased and, as of March 13, sits at its easiest setting since 2022.

Exhibit 1: Goldman Sachs US Financial Conditions Index

Source: Goldman Sachs, Bloomberg.

The Bloomberg index is by far at its easiest setting since before the Fed began to hike rates (Exhibit 2).  For the Bloomberg gauge, up is easier and down is tighter. In fact, the current readings are within about 5 bp of the easiest levels seen in 2021, which were the most accommodative since the 1990s.

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).

For the Chicago Fed National Financial Conditions Index, up is tighter and down is looser, with 0 representing the long-term median of conditions. The chart shows that by this measure, financial conditions are by far their easiest since February 2022—since before the Fed began to raise rates, in line with the Bloomberg index (Exhibit 3). For what it is worth, it also illustrates that the tightening of financial conditions that Fed officials were harping on back in October turned out, in retrospect, to be trivial, amounting to less than 5 bp on the index and fully reversed within a month.

Exhibit 3: Chicago Fed National Financial Conditions Index

Source: Chicago Fed.

Implications for monetary policy

Chair Powell and others on the FOMC have laid out a narrative in which the Fed is conducting a substantially restrictive monetary policy that is exerting a noticeable drag on the economy.  While that is undoubtedly true for the federal funds rate alone, the charts above suggest that the financial environment broadly remains quite easy, a plus rather than restraint for economic growth.  Some have begun to question whether the current rate setting is really restrictive, but I think a better place to look within the Fed’s array of policy settings is the balance sheet.  Many financial participants have been arguing for months that QT should be ended soon, but as I see it, the Fed’s still-bloated balance sheet is providing an environment conducive to high asset prices, ready availability of liquidity and credit, and, in turn, continued economic growth.

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

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