Although financial conditions are tighter now than in early 2022, they have retreated significantly in recent months.
At the February 1 Federal Open Market Committee (FOMC) meeting, Chair Powell fielded several questions on financial conditions. Financial conditions are important to the Federal Reserve (Fed) because the Fed influences the economy through financial conditions – it is how they know monetary policy is working. After months of maintaining that financial conditions were too loose, underpinning the Fed’s assertion that rates are not restrictive enough, Powell stated, “…financial conditions have tightened very significantly over the past year… our focus is not on short-term moves but on sustained changes to broader financial conditions.”
Although financial conditions are tighter now than in early 2022, they have retreated significantly in recent months. Three prominent indices– the Bloomberg Financial Conditions Index (BFCI), the Chicago Fed National Financial Conditions Index (CNFCI), and the Goldman Sachs Financial Conditions Index (GSFCI)—are the loosest since February, April, and August 2022, respectively. The divergence between the three can be explained by their respective methodologies.
- The BFCI equally weights bond, equity, and money market variables and has likely been driven by narrowing credit spreads and less market volatility as the market and the Fed coalesce around a 5% terminal rate.
- The CNFCI is comprised of 105 variables, but risk measures contribute to 58% of the index compared to 27% for credit and 15% for leverage. The stabilization in markets and spreads may overshadow the sharp rise in lending standards for commercial and industrial, credit card, and auto loans, and higher mortgage rates.
- The GSFCI uses just five variables but is most heavily weighted towards the 10-year U.S. Treasury yield and corporate BBB spreads. It closely tracks movement in 10-year yields, which peaked in late October. Yields have fallen as inflation has begun to moderate and growth is expected to slow, signs that Fed policy is working.
Although Chair Powell dismissed the fact that financial conditions have softened from their October peaks, this recent loosening is a reflection that monetary policy has already influenced economic conditions: disinflation has set in, housing and manufacturing are contracting, growth is slowing, and market volatility has relented in anticipation of a Fed that is not far from pausing.