How to Determine Whether Financial Conditions are Tight Enough, Despite Struggles Faced by the Fed
As anticipated by the market, the Federal Reserve kept interest rates unchanged in November, marking the first time during this tightening cycle that the Fed paused for two consecutive meetings. While the Fed still retains the possibility of future rate hikes, officials are being cautious and closely monitoring Treasury market fluctuations, stressing that rising U.S. Treasury yields could lead to a tightening of financial conditions that may impact both the economy and inflation.
The statement released after Wednesday's FOMC meeting noted that " Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation." It is noteworthy that the word "financial" was newly added to this statement as it previously only mentioned credit tightening.
1. The Fed's FCI-G index has once again surged higher
Towards the end of June earlier this year, the Fed proposed a new index for measuring U.S. financial conditions – the Financial Conditions Impulse on Growth (FCI-G) index. In comparison to the existing FCI index, the new index can not only measure whether financial conditions have tightened or loosened, but it can also evaluate to what extent these conditions are unfavorable or beneficial to economic activity and consider how future changes in financial variables may affect economic activities with a lag. In brief, higher index values indicate tighter financial conditions, while positive values imply headwinds for GDP growth during the upcoming year.
As depicted in the chart below, the FCI-G index turned positive for the first time in June 2022, and more recently, has continued to soar, indicating that financial conditions are once again tightening and resistance to future GDP growth is increasing once again.
The FCI-G relies on the recent three-month changes in seven financial variables, including the federal funds rate, the 10-year Treasury yield, the 30-year fixed mortgage rate, the triple-B corporate bond yield, the Dow Jones total stock market index, the Zillow house price index, and the nominal broad dollar index.
2. San Francisco Fed's proxy funds rate is significantly higher than effective federal funds rate
Proxy rates utilize public and private borrowing rates, as well as spreads, to infer the broader stance of monetary policy. Since the FOMC’s policy actions have an impact on financial conditions, the proxy rates translate them into a comparable level to the federal funds rate. In other words, it indicates how high the Fed's policy rate would be equivalent to current financial conditions.
Proxy rate employs a group of 12 financial variables, such as Treasury rates, mortgage rates, and borrowing spreads, to evaluate the wider stance of monetary policy.
As shown in the chart below, the proxy rate - the policy rate inferred from current financial conditions - was as high as 6.92% as of September 30th. This is notably higher than the effective federal funds rate of 5.33%, implying that the Federal Reserve's policy tightening effects may be more significant than those suggested by current policy rates.
3. Goldman Sachs's Financial Conditions Index also surged recently
Since July, one of Wall Street's most closely monitored indicators, the Goldman Sachs Financial Conditions Index (GSFCI), has surged significantly higher. This suggests that financial conditions are becoming more stringent, and a steeper curve implies that tightening is occurring at a faster rate.
GSFCI is a weighted average of short-term interest rates, long-term interest rates, the trade-weighted value of the dollar, an index of credit spreads, and the ratio of equity prices to the 10-year average of earnings per share.
The degree of financial tightening (or easing) serves as an indicator of the economy's health and future growth prospects. As such, it reflects the impact of increasing interest rates on the market and economy, making it a crucial factor for policymakers to take into consideration when formulating monetary policy. Similarly, investors can leverage this information to make informed decisions.
As JPMorgan's Global Market Strategist Meera Pandit stated earlier this year, " Financial conditions are important to the Federal Reserve (Fed) because the Fed influences the economy through financial conditions – it is how they know monetary policy is working."
According to Mark Hackett, Chief of Investment Research at Nationwide, these indexes can be viewed as "scorecards" that consider the factors influencing the economy, businesses, and consumers.
Source: Federal Reserve Bank of San Francisco, JPMorgan, Goldman Sachs, Bloomberg, Federal Reserve, Morningstar
Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only.
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SpyderCall : There is really valuable information here. It is important to know what the Fed is thinking about. Especially if you are a long-term investor.