How to Determine Whether Financial Conditions are Tight Enough, Despite Struggles Faced by the Fed

As anticipated by the market, the Federal Reserve kept interest rates unchanged in November, marking the first time during this tightening cycle that the Fed paused for two consecutive meetings. While the Fed still retains the possibility of future rate hikes, officials are being cautious and closely monitoring Treasury market fluctuations, stressing that rising U.S. Treasury yields could lead to a tightening of financial conditions that may impact both the economy and inflation.

The statement released after Wednesday's FOMC meeting noted that " Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation." It is noteworthy that the word "financial" was newly added to this statement as it previously only mentioned credit tightening.

Towards the end of June earlier this year, the Fed proposed a new index for measuring U.S. financial conditions – the Financial Conditions Impulse on Growth (FCI-G) index. In comparison to the existing FCI index, the new index can not only measure whether financial conditions have tightened or loosened, but it can also evaluate to what extent these conditions are unfavorable or beneficial to economic activity and consider how future changes in financial variables may affect economic activities with a lag. In brief, higher index values indicate tighter financial conditions, while positive values imply headwinds for GDP growth during the upcoming year.

As depicted in the chart below, the FCI-G index turned positive for the first time in June 2022, and more recently, has continued to soar, indicating that financial conditions are once again tightening and resistance to future GDP growth is increasing once again.

Proxy rates utilize public and private borrowing rates, as well as spreads, to infer the broader stance of monetary policy. Since the FOMC’s policy actions have an impact on financial conditions, the proxy rates translate them into a comparable level to the federal funds rate. In other words, it indicates how high the Fed's policy rate would be equivalent to current financial conditions.

As shown in the chart below, the proxy rate - the policy rate inferred from current financial conditions - was as high as 6.92% as of September 30th. This is notably higher than the effective federal funds rate of 5.33%, implying that the Federal Reserve's policy tightening effects may be more significant than those suggested by current policy rates.

Since July, one of Wall Street's most closely monitored indicators, the Goldman Sachs Financial Conditions Index (GSFCI), has surged significantly higher. This suggests that financial conditions are becoming more stringent, and a steeper curve implies that tightening is occurring at a faster rate.

The degree of financial tightening (or easing) serves as an indicator of the economy's health and future growth prospects. As such, it reflects the impact of increasing interest rates on the market and economy, making it a crucial factor for policymakers to take into consideration when formulating monetary policy. Similarly, investors can leverage this information to make informed decisions.