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Fed’s Tools Show Easing Financial Conditions, Fed Saying Otherwise

A conflict between bank lending activity and financial markets is putting the Fed in a quandary. According to NY Fed President Williams, the economy’s behavior proves that monetary policy is restrictive and is “clearly working the way the Fed wants it to work.” What does that mean exactly? Basically, he means that the series of rate hikes enacted between March 2022 and July 2023 slowed down economic activity. Federal Reserve Chairman Jerome Powell has frequently mentioned that those hikes tightened financial conditions, which caps growth in the economy, jobs, and, importantly, inflation.

The financial conditions index (FCI) can be defined as the mix of:

• Interest rates and credit spreads that determine how easily companies and consumers can acquire loans, which shapes business investment and household spending decisions;

• Stock prices, which causes people to spend more or less as their wealth changes, thereby  impacting consumption; and
• The level of the dollar, which affects the inflation rate of goods that we import.

Easy conditions mean stocks are high and interest rates are low, and tight conditions normally occur as stock prices fall and interest rates rise. Meanwhile, Powell, Williams, and the rest of the Federal Open Market Committee (FOMC) repeat that financial conditions are sufficiently tight. The fact is that financial conditions are easier now than when the Fed first started hiking interest rates. Even William’s own New York Fed’s measure of financial conditions shows financial conditions are basically neutral. When including past changes in financial variables, and not just the most recent data, the NY Federal Reserve FCI gauge reflects conditions that are boosting, not slowing, the economy.

Loose financial conditions do not normally happen after a string of Fed rate hikes. That is not supposed to be how things work. The explanation of why markets are bullish and the economy is growing despite the rate hikes is straightforward. It’s due to the enormous volume of fiscal spending. The federal money that has been flowing since the pandemic has kept the economy on a good footing, boosting labor demand and, therefore, consumption, which elevates the prices of services.

The only way the central bank should ignore its tools and conclude that financial conditions are tight is because banks have been stingy in their lending policies. Bank lending officers’ conservative stance in granting loans makes the actual flow of capital restrictive. But one cannot ignore that credit spreads are tight, and stocks are high, reflecting good prospects for business. This conflict between tight credit and upbeat measures of financial conditions may explain the Fed’s inaction on the Fed Funds rate lately. If fiscal policy continues to remain buoyant, perhaps banks will eventually ease their lending standards, which could force the Fed to tighten. If the economy finally begins to contract from the lack of lending,  that would cause the Fed to ease to help stave off a recession. Regardless, when these two forces converge, it will be destabilizing, and its resolution could be negative for risk markets.

Speaking in Tongues Part 2

Being caught between optimistic markets and pessimistic banks is a problem that the Fed inherited. However, through their own actions, they have produced another problem. The clear message coming out of FOMC voters is that they can remain patient before acting on rates. The problem with their messaging is that “acting on rates” only means an eventual cut. The more Fed speakers ignore the possibility of a rate hike, the more volatile markets can be if the environment does not match the central bank’s forecast. Two examples from FOMC speakers last week:

• Atlanta Fed’s Bostic: “I don’t think a rate hike will be required to reach the 2% goal.”
• New York Fed’s Williams: “Rate hikes are not the baseline forecast.”

Investors have been pummeled repeatedly by this theme, and that is a reason why the Fed Funds futures are pricing in only a 0.2% chance of a rate hike by December. If inflation or growth surprises on the upside—we expect it to be the former rather than the latter—then rate expectations will be jolted from their current view. Since the markets love stability and a clear forward path, rate perceptions could change abruptly and could be a source of major market volatility.

A Growing U.S. Export: Trade Tensions

The Biden administration has followed up on the Trump administration’s tariffs toward China. Just recently, tariffs on Chinese electric vehicle exports were proposed to increase from 25% to 100%. With the 2022 CHIPS and Science Act, U.S. semiconductor companies have been prohibited from exporting sophisticated chips to China that could be used for Artificial Intelligence projects. The restrictions have put NVIDIA and AMD in the spotlight; recently, they have been singled out after President Xi’s attempts to strengthen economic ties with the Middle East caused Washington to slow the licensing of NVIDIA and AMD semiconductors headed to the Middle East. The fear is NVIDIA and AMD technology will end up in China based on these improved business ties.

The administration is swimming upstream because many tech giants such as Amazon and Google has increased their business presence in the U.A.E. and Saudi Arabia. Additionally, the Saudis just funded a $40 billion fund targeted for A.I. deals, and President Xi hosted a summit last week between himself and Arab leaders to explore enhanced business ties in finance and technology. Trade in the region is something we should involve ourselves with, not try in vain to control. There are a host of reasons that trade restrictions are a suboptimal strategy, not the least of which is that it increases global investor anxiety. It is politically expedient, so unfortunately, this trend will continue no matter who ends up in the White House in November.

What to Look for This Week

1. Let’s start at the end of the week: Friday, June 7 at 8:30am E.S.T. is the nonfarm payrolls employment report. All leading indicators point to a downside surprise in the coming months; we will see if the May report begins that trend.

2. The Job Openings and Labor Turnover Survey (JOLTS) for April will be released on Tuesday June 4 at 10 am E.S.T. The widely followed openings rate data is ironically the least reliable data in the report. Focus on the Quits Rate, an indicator of how comfortable workers are about finding a new job. It has been dropping steadily for two years.

3. Thursday June 6 at 8:45 am E.S.T is the European Central Bank (ECB) press conference 30 minutes after their rate decision is announced. This is the most heavily announced rate cut in recent memory, but ECB President Christine Lagarde will try to walk back expectations for further cuts given the strong services inflation data released last week. We will be watching Euro foreign exchange rates against the Dollar and the Yen.