Jun 6, 2022
Fed Delivers Fuzzier Rate Message as It Gauges Impact of Hikes
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With half-point interest-rate increases all but certain in June and July, Federal Reserve officials are shifting the focus away from a destination on hikes to something that’s trickier to determine and explain: the broader impact of their policies on the economy.
At the start of the hiking cycle, Chair Jerome Powell said the goal was “getting rates back up to more neutral levels as quickly as we practicably can.” In May, however, he walked back from the concept of neutral -- a level that neither slows nor speeds up growth -- cautioning that the discussion had a “sort of false precision.”
“You know, you’re going to raise rates, and you’re going to be kind of inquiring how that is affecting the economy through financial conditions,” he said.
Policy makers delivered that message repeatedly last week, in their final comments before the Fed entered its pre-meeting blackout period.
Officials want to cool demand by tightening financial conditions. They don’t know with any precision how raising rates combined with a shrinking balance sheet crimps spending. It’s also hard to explain a financial conditions goal, though there are several indexes that try to boil down an array of market prices into a single gauge.
“We are certainly looking at financial conditions as a key guide as to how much policy tightening is required,” said David Page, head of macroeconomic research at AXA Investment Managers. “But there isn’t a standard metric. The precise balance is much more art than science.”
Powell used the term “financial conditions” more than a dozen times at his post-meeting press conference in May, noting that officials “need to look around and keep going if we don’t see that financial conditions have tightened adequately.”
He clearly wants to signal a goal, but the goal line is hard 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. That’s almost $400 in additional monthly payments on a $300,000 loan, and the added cost is slowing home sales.
But for a company financing inventory on 90-day commercial paper at around 1.5% -- when the Fed’s preferred gauge of inflation is running at 6.3% -- conditions might still seem cheap and easy.
Economists at Deutsche Bank use a financial conditions framework to assess how many more turns of the monetary wrench the Fed would need to return price pressures to their 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 US economist, Matthew Luzzetti.
Deutsche Bank says that would be more than 0.7 on the adjusted Chicago Fed National Financial Conditions Index, which right now is near zero.
Historically, 0.7 has corresponded with a recession probability over the next 12 months of 50%, Deutsche Bank estimates, and they forecast the Fed will have to push on into restrictive policy.
“If financial conditions continue to ease, they will have to be more hawkish,” Luzzetti said.
While financial conditions have tightened a lot since the Fed began signaling its intention to confront inflation, some credit costs have gotten cheaper in the last few days.
Societe Generale strategist Manish Kabra watches what he calls “Dr. Junk,” or the spread of junk bond yields over Treasuries, to assess how much wrenching the Fed will have to do on markets to crimp demand and whip inflation.
That spread has widened to at least 800 basis points every time the economy has gone into a recession. It got up to 480 basis points but has recently narrowed to 400 basis points, as investors revive the idea of a soft-landing for the economy where growth and inflation slow without crushing employment.
“The recent improvement in credit conditions is mostly because the Fed has provided clarity to the market as what they would be doing almost until September,” Kabra said, allowing investors to focus on fundamentals.
Nonfarm payrolls increased 390,000 last month and the unemployment rate held at 3.6%, a Labor Department report showed Friday, assuaging any concerns that the economy was in a steepening slowdown.
Minutes of the Fed’s May meeting suggested policy flexibility later in the year while Atlanta Fed chief Raphael Bostic floated the idea of a September rate-hike pause.
Fed Vice Chair Lael Brainard pushed back hard on that, telling CNBC on Thursday “it’s very hard to see the case for a pause,” while spelling out she wants a string of lower readings on monthly core inflation to give her confidence that policy is working.
Investors see a better-than-even chance the Fed will hike rates by 50 basis points in September, according to interest rate futures prices.
Just how shrinking the $8.9 trillion balance sheet interacts with markets and risk is another mystery.
“We need more of a framework around the balance sheet and financial conditions, and they have been slow to develop one,” said Julia Coronado, co-founder of MacroPolicy Perspectives LLC.
The challenge is that “for a given path of quantitative tightening the impact varies because it depends on how much risk there is in the world,” she said.
Fed Governor Christopher Waller told a Frankfurt audience on Monday that the planned annual $1 trillion runoff in the central bank’s holdings of Treasuries and mortgage-backed securities is probably equal to a 25 basis-point increase a year. But he warned that was only a rough judgment.
Bill Nelson, a former adviser to the Federal Open Market Committee, 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.
The balance sheet is now a “permanent part of the policy landscape,” said Nelson, who’s now chief economist at the Bank Policy Institute. “It is really not sound policy anymore to exclude FOMC participants’ views on the balance sheet” from their quarterly forecasts.
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