Officials want to cool demand by tightening financial conditions. They don’t know with any precision how raising rates combined with a shrinking balance sheet crimps spending. It’s also hard to explain a financial conditions goal, though there are several indexes that try to boil down an array of market prices into a single gauge.
Powell used the term “financial conditions” more than a dozen times at his post-meeting press conference in May, noting that officials “need to look around and keep going if we don’t see that financial conditions have tightened adequately.”
He clearly wants to signal a goal, but the goal line is hard for officials to define because some markets tighten quickly while others lag.
Thirty-year mortgage rates, for example, rose to a recent high of 5.6%, according to Bankrate.com., about 200 basis points above January. That’s almost $400 in additional monthly payments on a $300,000 loan, and the added cost is slowing home sales.
But for a company financing inventory on 90-day commercial paper at around 1.5% — when the Fed’s preferred gauge of inflation is running at 6.3% — conditions might still seem cheap and easy.
Economists at Deutsche Bank use a financial conditions framework to assess how many more turns of the monetary wrench the Fed would need to return price pressures to their 2% target.
“It would take a sharp and aggressive tightening of financial conditions from here to push inflation much closer to price stability,” says its chief US economist, Matthew Luzzetti.
Deutsche Bank says that would be more than 0.7 on the adjusted Chicago Fed National Financial Conditions Index, which right now is near zero.
Historically, 0.7 has corresponded with a recession probability of 50% over the next 12 months. While financial conditions have tightened a lot since the Fed began signaling its intention to confront inflation, some credit costs have gotten cheaper in the last few days.
