Fed frets over loose financial conditions as markets rally

By several measures, financial conditions are looser than they have been in years, igniting fresh concerns within the US Federal Reserve that the monetary policy push to bring down inflation through relatively steep borrowing costs is languishing.

The Chicago Fed's National Financial Conditions Index, a measure of conditions in money, debt and equity markets, and banking systems, fell in mid-May to the lowest level since November 2021, meaning that financial conditions are currently as loose as they were back when the Fed's benchmark interest rate was near zero. During the latest meeting of the rate-setting Federal Open Market Committee (FOMC), many Fed officials said they were uncertain about the degree of restrictiveness in current monetary policy, claiming that financial conditions may be "insufficiently restrictive" on demand and inflation, according to the minutes of the April 30 to May 1 meeting, which were released May 22.

Federal Reserve officials are not about to lower interest rates from the highest levels in decades, a stance that can typically challenge markets. Yet stocks have surged to all-time highs, corporate bond spreads are tumbling along with demand for the safety of government bonds, and market volatility has reached the lowest levels since before the pandemic, all of which have policymakers debating just what their next move on rates should be.

"The Fed's original plan was to hike rates a lot, tighten financial conditions, cause a recession, and then get inflation under control," said Joseph Wang, a former senior trader on the Fed's Open Markets Desk and the operator of Fedguy.com, a financial markets research blog. "The economy continues to grow above trend and inflation remains above target. This has led some officials to wonder if the current stance of policy is sufficiently restrictive."

'Smaller effects' of rate hikes

The Fed aimed to tighten financial conditions and bring inflation down to its 2% target when it began aggressively hiking rates in March 2022, a process that led them up to the current target level of between 5.25% and 5.50%. Even with the meteoric rise in interest rates, stocks continue to rally, corporate bond spreads are falling and inflation, while down from the highs of early 2022, remains stubbornly above the Fed's 2% target.

Personal consumption expenditures excluding volatile food and energy prices — the Fed's preferred inflation measure — fell 263 basis points from its February 2022 high to December 2023, yet is just 12 basis points lower through the first three months of 2024, according to the latest US Bureau of Economic Analysis data.

Fed officials during their most recent monetary policy meeting viewed the stubbornness of inflation as a possible sign that "high interest rates may be having smaller effects than in the past, that longer-run equilibrium interest rates may be higher than previously thought, or that the level of potential output may be lower than estimated," the FOMC minutes state.

Markets rally

Those officials are growing increasingly uneasy that looser financial conditions are signaling that the economy has yet to slow as expected when the Fed began raising rates, said Derek Tang, an economist with LH Meyer/Monetary Policy Analytics.

"In breaking down where the transmission is weaker, it appears that equities are the main aspect adding to, rather than dragging from, growth," Tang said.

The S&P 500, Nasdaq composite index, and the Dow Jones Industrial Average have hit all-time highs in May.

The CBOE Volatility S&P 500 index, the large-cap stock index's "fear gauge," fell in May to the lowest levels since before the pandemic. Meanwhile, investment grade and junk bond spreads, which measure the risk premiums by comparing corporate and equivalent Treasury bond yields, have fallen to the lowest levels since interest rates were at near zero.

"While inflation may have hit a four-decade high, the reaction in the economy and stock market were not the same as the 1980s," said Bret Kenwell, a US investment and options analyst at eToro. "Each economic cycle has its own qualities. If the Fed can thread the needle for a soft landing, then this policy was pretty effective, even if it takes longer than expected."

Rate path forward

Fed officials have pushed back against speculation of imminent rate cuts, with some indicating that the central bank may consider another rate hike if inflation fails to cool more. Central bankers want tighter financial conditions, though any time they indicate that monetary policy could be potentially eased it leads to looser financial conditions, which can be one reason for boosting economic activity and, in turn, inflation, said Gregory Daco, chief economist at EY-Parthenon.

"There is some validity to the fact that looser financial conditions may be supporting stronger spending by high-income individuals and corporations but not to the degree that it's leading to any form of economic reacceleration," Daco said.

Some Fed officials may not be concerned with the view that financial conditions are easing, downplaying the importance of equity prices and credit spread in favor of higher mortgage rates and rising credit card debt, which are signs of a looming economic slowdown, said Wang, the former Fed trader.

"They suggest that financial conditions are tight because the housing market has slowed and credit card delinquencies have picked up," Wang said.

Still, financial conditions will likely continue to loosen, Wang said, since Fed Chairman Jerome Powell has strongly indicated that the central bank's next move will be to cut rates.