The Big Idea
Easy financial conditions, despite a little panic
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For a time within the last week, financial market participants and even some economists argued that the Fed would be forced into an emergency intermeeting rate cut due to tightening financial conditions. For the moment, cooler heads seem to have prevailed, but this argument raises a broader question: are financial conditions tight? Fed officials have time and time again argued that policy is substantially restrictive, but financial conditions indicate otherwise.
Restrictive
Chair Powell and other Fed officials have repeatedly noted that the current policy rate setting is restrictive. The last quarterly set of FOMC forecasts compiled in June showed that the median projection for the long-run funds rate was 2.75%, while the current target is 5.375%. I would peg the long-run neutral policy setting at around 3.25%, which is also about where long-dated SOFR futures put it. Nonetheless, even if the Fed is overestimating the degree to which policy is currently tight, most would agree that, at 5.375%, the funds rate is restrictive by a significant margin.
As Powell has emphasized, the economy is certainly showing telltale signs of being restrained by Fed policy. The housing market has been relatively soft for close to two years. Fed officials have argued that business investment has been dampened by tight policy, and consumers have undoubtedly been hurt by high borrowing costs, as evidenced by the rise in credit card and auto loan delinquencies.
Financial conditions indices
Even so, there has been a stark contrast between a clearly restrictive policy rate setting and favorable broad financial conditions. Looking at several different financial conditions indices offers insight into 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 a handful 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- and long-term interest rates, the trade-weighted dollar, credit spreads, and a P/E ratio for stocks.
Based on the GS index, financial conditions were historically easy in 2021, when the FOMC was still conducting QE and before it began raising rates (Exhibit 1). 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 wildly this year, the GS Financial Conditions index has been roughly steady in easy territory. In fact, in mid-July, the index posted its lowest (easiest) reading of the year. The gauge tightened by about three tenths of a percentage point from the FOMC meeting through Wednesday, to a level not significantly different from the year-to-date average.
Exhibit 1: Goldman Sachs US Financial Conditions Index
Note: 100 = neutral, greater than 100 = tight, less than 100 = loose.
Source: Goldman Sachs, Bloomberg.
As for the Bloomberg measure, just a month ago, this measure was at essentially its all-time easiest (going back to 1990) (Exhibit 2). However, this gauge is clearly more sensitive to short-term swings in asset values. From the close on Monday July 29 to the close on Monday August 5, the Bloomberg FCI tightened by about 1.2 standard deviations. Over the following two days, the Bloomberg measure retraced over half of that tightening.
Exhibit 2: Bloomberg Financial Conditions Index
Note: 0 = neutral. Greater than 0 = looser. Less than 0 = tighter. Zero represents average conditions over the period from 1994 to July 1, 2008, and the index is scaled so that +1 represents one standard deviation easier than the mean and -1 represents one standard deviation tighter.
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, my favorite measure of financial conditions, 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.
Based on the Chicago Fed measure, financial conditions were, as late as mid-July, their easiest since late 2021, since before the Fed began to raise rates. The latest weekly reading is for August 2 and barely moved. To be fair, the August 2 reading could be revised tighter going forward.
Exhibit 3: Chicago Fed National Financial Conditions Index
Note: Up is tighter and down is looser, with 0 representing the long-term median of conditions. The index is scaled to standard deviations.
Source: Chicago Fed.
Status Quo Ante
At the height of the panic on August 5, financial markets priced high odds of an emergency Fed rate cut within days. One of the main arguments that I heard for such a move was that financial conditions were tightening dramatically, so that an already vulnerable economy would be further damaged by an increasingly restrictive financial atmosphere.
In such a scenario, initial conditions matter. If financial conditions swing from easy to tight in short order, that would likely have a discernible impact on how the Fed sees policy. In contrast, if financial conditions merely shift from extremely easy to moderately easy, the Fed can presumably afford to take a more relaxed approach.
For now, a crisis in financial markets appears to have been averted. Obviously, panic and an ensuing sharp tightening in financial conditions can strike at any time. However, in considering how the Fed might respond, it is important to keep in mind our starting point, and, in the current case, financial conditions appear to be quite easy, which means that it would take a drastic shift to take them into restrictive territory. In this environment, it is understandable that the Fed would prefer to take a patient approach rather than reacting to a brief panic, as financial market participants in the heat of the moment were calling for.
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