'LITTLE REASON FOR CONCERN': Why the Federal Reserve is unlikely to care about the recent slide in US stocks

Mark Wilson/Getty ImagesWhen a little’s not enough. US Fed Chairman Jerome Powell.
  • US stocks have fallen sharply this month, coinciding with a spike in US bond yields to fresh multi-year highs.
  • Despite recent market moves, financial conditions in the US remain more accommodative than usual, indicating little evidence of financial stress.
  • In combination with booming labour market conditions and strong economic growth, recent volatility in financial markets is unlikely to deter the US Federal Reserve from lifting official borrowing rates further .

US financial conditions still remain highly accommodative, even with the recent sharp selloff in stocks and lift in bond yields, meaning there’s little reason for the US Federal Reserve to abandon its plans to gradually tighten policy settings further in the period ahead.

As seen in the chart below from Bank of America Merrill Lynch (BAML), US financial conditions — whether measured by Bloomberg or the Chicago Federal Reserve — both sit at levels that are more accommodative than historic norms.

BAML

“Recent gyrations in stocks and bonds have led to a tightening in financial conditions, according to an aggregate measure produced by Bloomberg. However, the index still remains in accommodative territory,” BAML says.

“The Chicago Fed national financial conditions index had a more subdued response, continuing to head higher as of last week.

“In fact, the index is now at its easiest levels throughout the current cycle, and is at the best level since February 1994.”

According to the St Louis Fed, financial conditions indexes “summarise different financial indicators and, because they measure financial stress, can serve as a barometer of the health of financial markets”.

While each financial conditions index (FCI) is constructed differently, most use short and long-term bond yields, credit spreads, the value of the US dollar and stock market valuations to evaluate the degree of stress in US financial markets.

Right now, financial conditions in the US are looser than historic norms which, along with booming labour market conditions and strong economic growth, mean the Fed is unlikely to be deterred from raising official borrowing costs.

“The bottom line is that the recent market moves did not make much of a dent in overall conditions,” BAML says. “This gives the Fed little reason for concern.”

Based on the median forecasts offered by individual FOMC members in September, the Fed is forecasting one additional 25 basis point increase in the Fed funds rate this year, three next year, and another one in 2020, a scenario that will leave the Fed funds rate in a range of 3.25% to 3.5%, up from 2% to 2.25% at present.

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