At the start of the monetary tightening cycle, Fed Chairman Jerome Powell said the goal was to “get rates back to more neutral levels as quickly as possible.” In May, however, he pushed back on the concept of neutral, a level that neither slows nor accelerates growth, and warned that the discussion had a “kind of false precision.”
“What’s happening is we’re going to raise rates and we’re going to ask how that’s affecting the economy through financial conditions,” he said.
Central bankers delivered that message repeatedly last week in their final comments before the Fed entered its quiet period ahead of its next policy meeting.
Officials want to cool demand by tightening financial conditions. They don’t know precisely how raising rates combined with a shrinking balance sheet will restrain spending. It is also difficult to spell out a target for financial conditions, although there are several indexes that attempt to reduce a range of market prices into a single indicator.
“We are certainly looking at financial conditions as a key guide to how much policy tightening is required,” said David Page, head of macroeconomic analysis at AXA Investment Managers. “But there is no standard metric. Precise balance is much more art than science.”
Powell used the term “financial conditions” more than a dozen times in his post-meeting press conference in May, noting that officials “should look around and move on if we don’t see that financial conditions have tightened appropriately.”
He clearly wants to point to a target, but the finish line is difficult for officials to define because some markets tighten quickly while others lag.
Thirty-year mortgage rates, for example, rose to a recent high of 5.6%, according to Bankrate.com. about 200 basis points above January’s level. That equates to nearly $400 in additional monthly payments on a $300,000 loan, and the additional cost is slowing home sales.
But for a company financing inventory in 90-day commercial paper at around 1.5%, when the Fed’s preferred inflation gauge is 6.3%, the terms can still look cheap and flexible.
Deutsche Bank economists use a framework of financial conditions to assess the magnitude of monetary tightening the Fed would need to bring price pressures back to its 2% target.
“It would take a sharp and aggressive tightening of financial conditions from here to push inflation much closer to price stability,” says its chief U.S. economist, Mateo Luzzetti.
Deutsche Bank says it would be above 0.7 on the Chicago Fed’s adjusted national financial conditions index, which is currently near zero.
Historically, 0.7 has corresponded with a recession probability over the next 12 months of 50%, Deutsche Bank estimates, and they forecast that the Fed will have to push for tightening policy.
“If financial conditions continue to improve, it will have to get tighter,” Luzzetti said.
While financial conditions have tightened sharply since the Fed began signaling its intention to tackle inflation, some credit costs have become cheaper in recent days.
Société Générale strategist Manish Kabra tracks spreads in junk bond yields over Treasuries to gauge how much the Fed will have to do in the markets to curb demand and control inflation.
That spread has widened to at least 800 basis points every time the economy has gone into recession. It rose to 480 basis points, but recently narrowed to 400 basis points as investors revisit the idea of a soft landing for the economy where growth and inflation slow without crushing employment.
“The recent improvement in credit conditions is mainly because the Fed has provided clarity to the market on what they would be doing almost until September,” Kabra said, allowing investors to focus on fundamentals.
Nonfarm payrolls rose by 390,000 last month and the unemployment rate held at 3.6%, a Labor Department report showed Friday, easing any concerns that the economy was in a steep slowdown.
Minutes from the Fed’s May meeting suggested policy flexibility later in the year, while Atlanta Fed chief Raphael Bostic floated the idea of a pause in rate hikes in September.
Fed Vice Chair Lael Brainard strongly rejected that view, telling CNBC on Thursday that “it’s very hard to see the case for a pause,” while explaining that it requires a series of lower readings on monthly core inflation to have confidence that policy is working.
How the $8.9 trillion balance sheet reduction interacts with markets and risk is another mystery.
Fed Governor Christopher Waller told an audience in Frankfurt on Monday that the planned annual outflow of US$1 trillion in the central bank’s holdings of Treasuries and mortgage-backed securities is probably equal to a 25 basis point increase per year. But he cautioned that it was only a rough judgment.
Bill Nelson, a former advisor to the Federal Open Market Committee (FOMC) said one step officials could take would be to include a balance sheet forecast in their outlook, since that is already implicit in their rate projections.
Balance is now a “permanent part of the policy outlook,” said Nelson, who is now chief economist at the Bank Policy Institute. “It’s really no longer good policy to exclude FOMC participants’ views on the balance sheet” from their quarterly forecasts.