The Big Idea
Removing a dose of accommodation
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Fed Chair Warsh offered a comprehensive case for raising rates, citing economic strength, stubbornly high inflation and a persistent increase in oil and commodity prices due to a shift in the geopolitical situation. Warsh also repeated a point he made at Jackson Hole: broad financial conditions are far from restrictive. Measures of financial conditions confirm that, despite a longstanding view of many Fed officials that monetary policy was modestly restrictive, the broad environment has been easy for some time.
Fed funds rate and neutrality
Central bankers have long compared the policy rate with an estimate of neutral. A “neutral” rate is the setting that neither stimulates nor restricts the economy over time. It is impossible to observe neutral in the real world, so officials guess where it lies and adjust based on how the economy responds to various interest rate levels.
The FOMC’s quarterly “dot” projections include estimates of the “longer-run” funds rate, a close proxy to policymakers’ view of neutral. Comparing the FOMC’s quarterly median estimates of neutral with the actual funds rate target helps show how Fed officials regarded the stance of its rate policy (Exhibit 1).
Exhibit 1: Target Fed funds rate compared to long-run neutral
Source: Federal Reserve.
By this gauge, monetary policy has been restrictive since the summer of 2022, when the rapid hiking cycle took the policy rate above the Fed’s then-current estimate of a roughly 2.5% neutral level. This is why so many Fed officials have been referring to policy this year as “modestly restrictive.”
Financial conditions indices
Financial conditions include far more than the overnight fed funds rate. Various indices try to measure broad financial conditions. Two different ones offer a picture that is quite far from “modestly restrictive.”
The Bloomberg Financial Conditions index is relatively simple. It includes a few money market spreads, several bond spreads, and, for equities, the S&P 500 and the VIX. For the Bloomberg gauge, up is easier and down is tighter (Exhibit 2). 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.
As the graph shows, this index has spent almost all of the last three years above zero, meaning financial conditions have been easier than usual. The few dips below zero were generally tied to events with little connection to monetary policy. In early 2023, the failure of SVB and several other banks led to a period of tightness. In the summer of 2024, there was a momentary panic over the unwind of the carry trade globally. And then the brief drops in 2025 and 2026 followed Liberation Day and the US-Iran conflict, respectively. None of these episodes lasted very long, and none was related to Fed policy.
By this measure, financial conditions over the past month or so have been the easiest in recent years. In fact, the local peak set in August was the highest, or easiest, reading in more than 30 years.
Exhibit 2: Bloomberg Financial Conditions Index
Source: Bloomberg.
The Chicago Fed National Financial Conditions Index offers a broader view. It is my preferred measure because it includes 105 measures of financial activity. Along with market prices and spreads, it includes responses from the Federal Reserve Board’s Senior Loan Officer Survey, the NFIB small business survey, and the University of Michigan survey of consumers. Unlike the Bloomberg measure, it does not update daily. It is calculated weekly, with revisions, and some components are reported less often. The Senior Loan Officer survey, for example, is conducted only quarterly. That makes the index less timely, but broader.
For the Chicago Fed National Financial Conditions Index, up is tighter and down is looser, with 0 representing the long-term median of conditions and, like the Bloomberg composite, it is scaled to standard deviations (Exhibit 3). By this measure, financial conditions consistently have been easier than average over the past six years. Moreover, as with the Bloomberg gauge, the Chicago Fed index indicates that financial conditions have loosened considerably this year. By this gauge, financial conditions are currently roughly at their easiest since just before the Fed began to hike rates off of the zero bound in early 2022.
Exhibit 3: Chicago Fed National Financial Conditions Index
Source: Chicago Fed.
Conclusion
Financial condition indices help explain why Chair Warsh noted at Jackson Hole and repeated Wednesday that “I would be hard-pressed to describe broad financial conditions as restrictive,” He added that the bulk of the FOMC generally shares that view. The FOMC appears to be warming to the view long held by a group of hawkish policymakers that a neutral policy setting is actually noticeably higher than the current consensus thinks. The median longer-run dot inched up to 3.25% in the most recent estimates, its highest level in more than a decade.
The Fed may be willing to push the envelope if modest hikes fail to curb inflation. Warsh described the September rate hike as removing a “dose of accommodation,” which leaves open the possibility that at least some on the FOMC believe that the new policy stance is still in easy territory rather than restrictive. I still expect the Fed to raise rates only one more time and then hold steady for an extended period until inflation finally slides back close to 2%, but the rhetoric of Warsh and the FOMC opens the door to a more aggressive approach.
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