The Big Idea
A deep dive on financial conditions
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Fed officials and financial market participants frequently discuss financial conditions. Fed officials have for the past two years often argued that the policy rate is restrictive, even as broader financial conditions measures pointed to a relatively easy environment. A detailed look at the Chicago Fed Financial Conditions Index offers a compelling case that financial conditions are quite accommodative, despite the still-elevated level of policy rates.
The Chicago Fed Financial Conditions Index
Financial market participants typically think of market-based indices like the Goldman Sachs or Bloomberg gauges when assessing financial conditions. However, both of these measures incorporate only a handful of metrics. 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. The financial conditions index that most 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 Opinion 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 Opinion Survey is conducted only once a quarter.
With the Chicago Fed National Financial Conditions Index, up is tighter and down is looser, with 0 representing the long-term median of conditions (Exhibit 1). The index also is scaled to standard deviations. The chart shows that by this measure, financial conditions are at their easiest since late 2021, since before the Fed began to raise rates. In fact, the only times over the past 15 years when the Chicago Fed index signaled easier financial conditions were two stretches from 2013 to 2014 and 2020 to 2021 when the FOMC was holding policy rates at the zero bound and simultaneously buying a substantial amount of securities to expand the balance sheet.
Exhibit 1: Chicago Fed National Financial Conditions Index
Source: Chicago Fed.
Additional detail
Chicago Fed researchers provide further detail in their calculations, dividing the 105 line items in the aggregate index into three components. The first is risk and captures volatility and funding risk in the financial sector. Again, positive numbers are tighter than average, and vice versa. The current reading on the risk component of the Chicago Fed FCI, at -0.63, is the lowest since late 2021 and near levels seen for much of the decade preceding the pandemic (Exhibit 2).
Exhibit 2: Chicago Fed National FCI Risk Component
Source: Chicago Fed.
The second component measures credit conditions, such things as consumer loan spreads, delinquency rates, and lending standards. The credit component of the Chicago Fed National FCI is in easy territory, but by much less, at -0.11 (Exhibit 3).
Exhibit 3: Chicago Fed National FCI Credit Component
Source: Chicago Fed.
Finally, the third component of the Chicago Fed National FCI is leverage, which captures various measures of debt and equity and is shown in Exhibit 4. It too is decisively in easy territory, at -0.46, though this component was considerably easier in the fall, reaching settings in September and October that were only seen in recent years in 2018 and 2021. Still, the latest readings are quite easy compared to the history of the past 15 years.
Exhibit 4: Chicago Fed National FCI Leverage Component
Source: Chicago Fed.
Conclusion
What do these three components tell us? My main takeaway is that the extraordinary amount of largesse that was provided to the economy during the pandemic by the combination of federal government disbursements and Fed security purchases has created an overhang of liquidity that continues to drive easy financial conditions via the “risk” and “leverage” components of the Chicago Fed FCI. Despite the Fed’s best efforts to absorb it, all of the excess liquidity sloshing around in the economy and financial system since 2020 has creating a very forgiving financial environment. This may help to explain why the economy has so outperformed expectations over the past few years despite a level of restrictiveness on the policy rate that would have been considered unimaginable in 2021 (at the beginning of 2022, financial market participants believed that the Fed would not be able to push the funds rate target above 2% for at least a decade).
The persistence of easy financial conditions has begun to move the needle for some of the more hawkish Fed officials. On January 9, Governor Bowman noted: “I also continue to be concerned that the current stance of policy may not be as restrictive as others may see it. Given the ongoing strength in the economy, it seems unlikely that the overall level of interest rates and borrowing costs are providing meaningful restraint. With equity prices more than 20 percent higher than a year ago, easier financial conditions may be contributing to the lack of further progress on slowing inflation.” A few other Fed officials have also noted that a “neutral” policy stance may be at a rate substantially higher than many believe. Presidents Logan and Schmid, among others, have suggested as much recently.
It is impossible to disentangle entirely the economic and financial effects of the policy rate and the size of the Fed’s balance sheet, but it may be the case that it is a still-bloated Fed balance sheet, not the funds rate setting, that is driving easy financial conditions.
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