- The US Federal Reserve says financial conditions are easing despite higher US interest rates
- US wage and inflation data has topped expectations since the Fed met in late January. The government has delivered a large fiscal stimulus package
- Westpac Bank says this could see the Fed hike rates faster and higher than markets currently expect
Now here’s an interesting paragraph from the minutes of the US Federal Reserve’s January FOMC meeting released on Wednesday.
Many participants noted that financial conditions had eased significantly over the intermeeting period; these participants generally viewed the economic effects of the decline in the dollar and the rise in equity prices as more than offsetting the effects of the increase in nominal Treasury yields.
So we know the question you’re asking — what are “financial conditions” and why is this interesting?
According to the St Louis Fed, financial conditions indices “summarise different financial indicators and, because they measure financial stress, can serve as a barometer of the health of financial markets”.
Using short and long-term bond yields, credit spreads, the value of the US dollar and stock market valuations, it attempts to measure the degree of stress in financial markets.
What the minutes conveyed in January was despite a lift in longer-dated bond yields, strength in stocks and decline in the US dollar suggest that financial conditions still improved.
So why is that important?
According to Elliot Clarke, economist at Westpac, it suggests the Fed may need to hike rates more aggressively than markets currently anticipate.
“That financial conditions have eased at a time when the FOMC is tightening policy will grant confidence that downside risks associated with further gradual rate increases and quantitative tightening are negligible,” he says.
“More to the point, this implies that risks to the FOMC rate view, and Westpac’s, are arguably to the upside.”
Adding to those risks, and even with the correction in US stocks seen after the January FOMC meeting was held, Elliot says in February “we have seen a further significant increase in government spending and signs of stronger wages”.
He also says the stronger-than-expected consumer price inflation in January — also released after the FOMC meeting was held — “will have also given the FOMC greater cause for confidence that inflation disappointment is behind them and that the risks are instead skewed to inflation at or moderately above target”.
As such, Elliot says the tone of the January minutes points to gradual rate rises from the Fed, mirroring what was seen last year.
However, the risk to this view, he says, is for more and faster hikes in the years ahead.
“In these circumstances, a continued ‘gradual’ increase in the fed funds rate through 2018 and 2019 — implying five hikes in total — is still the best base case,” he says.
“However, a careful eye will need to remain on financial conditions.
“Should they continue to move in the opposite direction to policy, a more concerted effort by the FOMC may prove necessary to keep the economy on an even footing.”