Analysis: Easing financial conditions threaten central bank’s fight against inflation By Reuters

Analysis: Easing financial conditions threaten central bank's fight against inflation By Reuters

© Reuters. FILE PHOTO: The Federal Reserve Building is seen in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie

By Yoruk Bahceli

(Reuters) – The U.S. Federal Reserve is raising interest rates at the most aggressive pace in a generation, but the financial conditions it must tighten to control rising inflation are going in the wrong direction.

A rally in stocks and falling government bond yields since the Fed’s June hike means financial conditions are easing, even as the U.S. economy has been hit by a set of 150 basis points rate hikes at that meeting and the next.

Financial conditions reflect the availability of finance in an economy. They dictate the spending, saving and investment plans of businesses and households, so central banks want them to step in to help control inflation, which is now well above their target levels.

A closely followed U.S. Financial Conditions Index (FCI) compiled by Goldman Sachs (NYSE: ), which takes into account borrowing costs, equity levels and exchange rates, has eased about 80 basis points (bp ) since the Fed meeting in June.

A similar Chicago Federal Reserve index, which tracks financial conditions independently of prevailing economic conditions, has turned negative, implying that conditions are loose relative to what the economic picture would normally suggest current

In the euro zone, conditions have also eased by about 40 basis points, according to Goldman Sachs, and money markets have offset most of the 2023 rate hikes they had previously expected.

“In June we thought (US) financial conditions were where they needed to be to engineer the slowdown you need to bring activity, wage growth and price inflation to target,” said Daan Struyven, senior global economist at Goldman Sachs.

“Our best guess is that they relaxed a little too much.”

Chart: US financial conditions to ease –

The change in conditions has been driven by recession fears, which have caused markets to not only cut back on how much they expect the Fed to hike, but also to price in rate cuts next year. That suggests investors think the Fed will be more concerned about a slowing economy than inflation next year.

Some investors also interpreted Fed Chairman Jerome Powell’s comments after the bank’s rate hike in July as implying a “peaceful pivot.”

Money markets now expect the Fed’s rate hikes to stop at around 3.6% next March, down from a more expected 4% before the June hike, followed by around 50bps of cuts to end of 2023.

Since the June rally, it has gained 13%, oil prices are down 22% and US 10-year Treasury yields are down 70bps. Credit markets have also recovered.

Of course, financial conditions remain about 200bps tighter than the all-time low of late 2021, and stocks remain up 10% for 2022.

Goldman estimates that a 100bp tightening in its FCI will reduce economic growth by one percentage point next year.

But the recent loosening comes close to what the bank calls the “FCI loop,” Struyven said.

“If you were to see additional financial conditions loosening very significantly, it probably wouldn’t be sustainable because the outlook for activity, wage growth and inflation would look too hot.”

UNFINISHED WORK

This risk is already reflected in market indicators of long-term inflation expectations.

The US 10-year breakeven rate has risen about 15bps to 2.44% since early July. Expectations for the Eurozone have also increased.

“This dovish interpretation was the reason why inflation expectations rose again. This just shows that the Fed still has unfinished business ahead of it,” said Patrick Saner, head of macro strategy at Swiss Re ( OTC :).

Data last week showing that US inflation was flat in July instead of rising prompted a further easing of financial conditions.

But recent data on U.S. employment and wage growth point to increasingly tight labor markets.

Economists note that the US unemployment rate of 3.5% is well below the lowest level (4.4% according to the Congressional Budget Office) it can reach without increasing inflation.

Annual wage growth of 5.2% is well above the 3.5% that Goldman estimates is needed to bring inflation down to the Fed’s 2% target.

PUSHING BACK

Several Fed policymakers have dismissed the shift in market prices, emphasizing a determination to continue tightening policy until price pressures ease.

They also say the Fed is unlikely to pivot to a rate cut in 2023. A pricing in of those cuts would tighten financial conditions.

Financial conditions need to tighten further, and for that to happen, “you need to see some declines in risk assets, share prices or increases in long-term yields. It’s usually a combination,” Saner said.

Goldman Sachs expects 10-year US Treasury yields to reach 3.30% by the end of the year, up from 2.80% today.

Others are skeptical of current equity valuations. Morgan Stanley (NYSE: ) expects the S&P 500 to fall 9% in June next year.

Analysts at UBS note that the stock market is currently consistent with core inflation returning to 1.5%-2%. If it ends up being a percentage point, the valuation adjustments imply a 25% drop in the S&P 500, they estimate.

“Wishful thinking in the markets only makes things harder, loosening financial conditions and requiring more monetary tightening to compensate,” Bill Dudley, former head of the New York Fed, warned in an opinion piece for Bloomberg News earlier this month. of August



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About the Author: Chaz Cutler

My name is Chasity. I love to follow the stock market and financial news!