Fed gauge signals high rates are doing little to constrain US economic growth

A key measure of US financial conditions has slipped to its lowest level since early 2022, a sign that the Federal Reserve's monetary policy may be doing little to restrain economic growth and that long-awaited rate cuts may be further off than many expect.

The Federal Reserve Bank of Chicago's National Financial Conditions Index dropped to negative 0.51 at the end of March, according to the latest update April 3. The index has fallen from 0.41 at the start of the pandemic in April 2020 and from the most recent peak of negative 0.10 in October 2022, indicating that conditions are nearing the most accommodative for economic growth since the Fed was holding interest rates at near zero.

The index measures how several variables including the federal funds rate, bond yields, mortgage rates, stock market performance and the dollar's exchange rate impact economic activity. A reading above zero indicates that conditions are likely restraining GDP growth, while readings below zero generally signal a supportive environment for economic growth. The recent decline shows that the economy remains ripe for growth even with the Fed hiking its benchmark interest rate by 525 basis points since March 2022. Fed watchers believe that this may cause officials to grow increasingly wary of cutting rates.

"Policy has not been restrictive enough relative to the economy to keep financial conditions tight," said Michael O'Rourke, chief market strategist with JonesTrading. "The longer that state is allowed to persist without additional tightening, the longer it will take for financial conditions to tighten and the economy to slow."

Higher for longer

The Fed has not moved rates since July, and with financial conditions continuing to loosen, expectations for rate cuts in 2024 could be further pared back.

"If anything, the Fed considers easing financial conditions as working its objectives of tightening monetary policy to ease demand and inflationary pressures," said Gregory Daco, chief economist at EY-Parthenon. "Thus, looser financial conditions favor a higher-for-longer stance."

The loosening of financial conditions has historically been linked to a positive macroeconomic environment for financial markets.

The ongoing downtrend in the financial conditions index will likely remain bullish for stocks, which have soared over the past six months, said Tom Essaye, a trader and founder of financial research firm The Sevens Report.

The index, however, has reached levels that have traditionally compelled the central bank to adjust monetary policy.

"The Fed raising rates from current levels is rather unlikely based on recent Fed meeting outcomes, but Fed 'jawboning' market yields higher in an attempt to stop the easing trend in financial conditions is not only possible, it is becoming increasingly likely," Essaye wrote in an April 1 note. "Such a hawkish shift in Fed tone and subsequent policy expectations would be bad for the stock market rally and risk assets broadly."

Tighter monetary policy is weighing on demand while economic growth and employment remained strong, Fed Chairman Jerome Powell said in an April 3 speech at Stanford University.

"This combination of outcomes reflects significant improvements in supply that offset to some extent the effects on demand of tighter financial conditions," Powell said.

Fed officials "do think that financial conditions are weighing on economic activity," and they are closely monitoring the effects of policy, Powell said during a press conference in March after the rate-setting Federal Open Market Committee's meeting.

"The Fed is watching this," said Satyam Panday, chief US economist at S&P Global Ratings. "They have to."

Constant struggle

While financial conditions are broadly loosening, rising interest rates and tighter bank lending standards are constricting activity, said Oren Klachkin, a financial market economist at Nationwide.

"The problem is accommodative conditions in other parts of the market — tight corporate bond spreads and rising equities, to name just two — are more than overwhelming the drags," Klachkin said. "We've more than unwound all the tightening in conditions that occurred in late 2023. You can easily argue that conditions are bolstering growth when the economy and inflation are already running hot."

While Powell has not indicated when rate cuts will begin, he and other Fed officials have signaled that cuts are coming and more hikes are not being seriously considered, creating an expectation of looser monetary policy that has already fed into the economy, Klachkin said.

"This is the Fed's constant struggle," Klachkin said. "They offer forward guidance to not surprise investors, even though it makes it harder to hit their dual mandate."

With loose financial conditions fueling aggressive investor behavior and boosting the risk of a future, sharp downturn in the markets and larger economy, the Fed may keep rates at current levels far long than many have forecast. And with the Fed potentially stuck in a policy-holding pattern, much depends on just how much looser financial conditions get.

"I think the risk to the market is investors believing the easy conditions will continue at the current levels," said O'Rourke with JonesTrading. "Chairman Powell is likely correct the economy will continue to decelerate, but as it remains resilient rates will remain higher for longer, which will eventually lead to conditions tightening, which becomes a risk for markets."