Analysis: Easing financial conditions threaten central bank’s inflation fight

The Federal Reserve Building is pictured in Washington, DC, U.S. August 22, 2018. REUTERS/Chris Wattie

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  • US financial conditions ease 80 basis points since June – Goldman Sachs
  • Eurozone conditions are also easing as equities rise and yields fall
  • Easing conditions make it harder for central banks to control inflation

Aug 16 (Reuters) – The U.S. Federal Reserve is raising interest rates at the most aggressive pace in a generation, but the financial conditions it needs to rein in soaring inflation are headed in the wrong direction.

A rally in equities and falling government bond yields since the Fed hike in June means that financial conditions are actually easing, although the US economy has been hit by a combined rate hike of 150 points. basis at this meeting and the next.

Financial conditions reflect the availability of finance in an economy. They dictate the spending, saving and investment plans of businesses and households, so central banks want them to tighten them to help control inflation, which is now well above their target levels.

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A widely-tracked U.S. Financial Conditions Index (FCI) compiled by Goldman Sachs, which takes into account borrowing costs, equity levels and exchange rates, has lost some 80 basis points (bps) since the June meeting. from the Fed.

A similar index from the Chicago Federal Reserve, which tracks financial conditions independently of prevailing economic conditions, turned negative, implying that conditions are loose compared to what the current economic situation would usually suggest.

In the euro zone, conditions have also eased by around 40 basis points, according to Goldman Sachs, and money markets have priced in most of the 2023 rate hikes they had previously anticipated.

“In June, we thought (US) financial conditions were broadly where they needed to be to bring about the slowdown you need to get activity, wage growth and price inflation back on target,” said Daan Struyven, senior global economist at Goldman Sachs.

“Our best guess is that they’ve slacked off a bit too much.”

US financial conditions ease

The change in conditions was driven by recession fears, which prompted markets to not only scale back how much they expect the Fed to rise, but also to price in rate cuts next year. This suggests that investors think the Fed will be more concerned about a slowing economy than inflation next year.

Fed Chairman Jerome Powell’s comments following the bank’s rate hike in July were also interpreted by some investors as implying a “dovish pivot”.

Money markets now expect Fed hikes to end at around 3.6% next March, down from more than 4% expected before the June hike, followed by around 50 basis points of cuts by the end of 2023.

Since the June rally, the S&P 500 has gained 13%, oil prices have fallen 22% and 10-year US Treasury yields have fallen 70 basis points. Credit markets have also recovered.

To be sure, financial conditions are still around 200 basis points tighter than the record low at the end of 2021, and equities remain down 10% for 2022.

Goldman estimates that a 100 basis point tightening of its FCI will reduce economic growth by one percentage point in the coming year.

But the recent easing is approaching what the bank calls an “FCI loop”, Struyven said.

“If you see a very significant further easing in financial conditions, it probably wouldn’t be sustainable because the outlook for activity, wage growth and inflation would look too warm.”

UNFINISHED WORK

This risk is already reflected in market indicators of long-term inflation expectations.

The US 10-year equilibrium rate has risen some 15 basis points to 2.44% since early July. Eurozone expectations have also increased. ,

“This dovish reading is why inflation expectations have risen again. It just shows that the Fed still has unfinished business ahead of it,” said Patrick Saner, head of macro strategy at Swiss Re.

Last week’s data showing that US inflation was flat in July instead of rising fueled further easing in financial conditions.

But recent data on US employment and wage growth point to increasingly tight labor markets. Read more

Economists note that the US unemployment rate, at 3.5%, is well below the lowest level – 4.4% according to the Congressional Budget Office – that it can reach without stimulating inflation.

The 5.2% annual wage growth is well above the 3.5% Goldman estimates is needed to bring inflation back to the Fed’s 2% target.

REPELLENT

Several Fed policymakers pushed back on the change in market prices, underscoring their determination to continue to tighten policy until price pressures ease. Read more

They also say the Fed is unlikely to turn to a rate cut in 2023. Pricing those cuts would tighten financial conditions. Read more

Financial conditions need to tighten further and for that to happen, “you either need to see a decline in risk assets, equity prices, or an increase in longer-term yields. It’s usually a combination,” he said. Saner said.

Goldman Sachs expects 10-year US Treasury yields to hit 3.30% by the end of the year, up from 2.80% today.

Others are skeptical of current stock valuations. Morgan Stanley expects the S&P 500 to fall about 9% by June next year.

UBS analysts note that the stock market is currently consistent with core inflation returning to 1.5%-2%. If it ends up rising by one percentage point, the valuation adjustments imply a 25% decline in the S&P 500, they estimate.

“Wishful thinking in the markets only complicates the task, easing financial conditions and demanding more monetary tightening to compensate,” former New York Fed chief Bill Dudley warned in an opinion piece. for Bloomberg News earlier in August.

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Reporting by Yoruk Bahceli, additional reporting by Samuel Indyk; Editing by Tommy Reggiori Wilkes and Hugh Lawson

Our standards: The Thomson Reuters Trust Principles.

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