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Are Financial Conditions Looser Than Fed Policy Suggests?

2024-10-31 14:49:58.625000

As of October 31, 2024, the U.S. economy is experiencing a notable disconnect between real interest rates and financial conditions. The Federal Reserve's inflation-adjusted policy rate is currently near its highest level since 2007, following a 50 basis point cut in September. Estimates of the neutral interest rate, referred to as 'R-Star,' range from 0.7% to 1.2%, indicating a complex landscape for monetary policy. Despite this, financial conditions have loosened significantly, driven by a remarkable 40% rise in stock prices over the past year, which has contributed to the loosest financial conditions seen in years. The U.S. GDP growth was reported at an annualized rate of 2.8%, suggesting resilience in the economy. However, real borrowing costs are at a 17-year high, raising questions about the sustainability of this growth. Economists at BNP Paribas have suggested that easing financial conditions could potentially boost GDP by an additional 0.7 percentage points. Joe Lavorgna, an economist, noted that the gains in the stock market are influencing broader financial conditions, which may lead to a shift in the Fed's approach. Fed Chair Jerome Powell has indicated that a transition to a neutral policy stance has begun, reflecting a response to the evolving economic landscape. This situation highlights the ongoing debate about whether the Fed's policy is too tight or too loose in light of current financial conditions and economic indicators. [053422ac]

In the context of these developments, financial conditions in major advanced economies have remained tight due to a series of global shocks stemming from the Covid-19 pandemic. Inflation rates in the US and Euro-Area reached 9.1% and 10.7% respectively, far above the 2% target. Central banks have reacted by increasing policy rates, with the European Central Bank (ECB) raising its main refinancing rate by 450 basis points to 4.5% and the Federal Reserve Board (FRB) increasing its policy rates by 525 bps to 5.5%. These rate hikes have led to elevated financial conditions, characterized by higher costs of credit and contracting volumes of credit. The tight financial conditions are expected to persist in the US and Euro-Area through the first half of 2024. Two main factors support this outlook: high policy rates due to core inflation remaining above 4% and the continued draining of liquidity in the banking systems by the ECB and FRB through balance sheet reductions. Financial conditions in November 2023 eased at the fastest pace in 40 years, raising concerns about the Federal Reserve's ability to cut interest rates. The Goldman Sachs Group U.S. financial conditions index dropped nearly a percentage point due to soaring stocks, falling Treasury yields, sliding crude-oil prices, a weaker U.S. dollar, and tighter credit spreads. While these conditions have positive effects on the economy, such as boosting the wealth effect and making U.S. goods more attractive globally, they also raise concerns about inflation. The Fed has not shown concern about the easing financial conditions, but if they determine that conditions have eased too much, they can push back against hopes for interest-rate cuts. The latest economic data does not warrant this concern, as inflation has remained flat and price pressures have eased since the summer of 2022. However, if the slowdown in the economy is not pronounced enough, it could lead to faster inflation. The labor market is weakening, and there are risks that if it doesn't weaken enough, inflation could rise. The tightening credit and lending conditions in the U.S. are building a case for the Federal Reserve to hold its policy rate at the next meeting. Despite the benchmark rate remaining unchanged since July, rates on the open market have been increasing, which could potentially slow down the strong economy. The October Senior Loan Officer Opinion Survey (SLOOS) conducted by the Federal Reserve is expected to shed light on the lending environment. Previous survey data indicates that banks have tightened loan standards, demand has weakened, and loan growth has slowed. The rise in the yield on the benchmark 10-year Treasury note is also anticipated to have a cooling effect on the economy. U.S. commercial bank credit has declined, primarily driven by a drop in the value of Treasury bonds and mortgage-backed securities. Additionally, there has been a decrease in loan demand, with an increase in delinquency reported for consumer loans. These factors point towards a weaker fourth quarter and further slowing in the coming year, providing more justification for the Federal Reserve to maintain the current interest rates. FX markets have handed back a little more of their risk-on gains overnight, leaving the dollar marginally stronger. However, US ten-year Treasury yields are still down at 4.65% and last night’s release of the Fed’s Senior Loan Officers Survey serves as a reminder that credit conditions are tightening and lending growth is weakening – both of which are likely to weigh on the US economy over coming quarters. The Atlanta Fed raised its estimate for fourth-quarter real-GDP growth to 2.6% following the Federal Reserve's dovish policy announcement. The phrase 'animal spirits' was used to describe the renewed hope and confidence in financial markets after the Fed's update. Financial conditions improved with declining Treasury yields, and confidence in a soft landing scenario increased. However, concerns were raised about financial markets declaring victory against inflation on behalf of Fed Chairman Jerome Powell. Fed funds futures traders priced in the possibility of five to seven rate cuts for 2024. [cee2f3f2]

Canada's financial conditions remain underwater, signaling slow growth in the first and second quarters. Consumption growth in the last two quarters was close to zero, and business investment has been volatile but essentially flat over the past year. The Bank of Canada's Senior Loan Officer Survey for the fourth quarter will provide a fuller picture of commercial lending. The RSM Canada Financial Conditions Index remains negative due to increased levels of risk and volatility in the bond market and the decline in commodity prices. The Bank of Canada is expected to gradually moderate rates once it is sure that the post-pandemic surge in demand has cooled and inflation has receded enough. A rate cut in April followed by three 25 basis-point rate cuts by the end of the year would be appropriate. The Canadian economy is highly dependent on its resource sector, making its exchange rate vulnerable to changes in commodity prices. The Bank of Canada's Senior Loan Officer Survey for the third quarter confirmed excess risk priced into financial assets. Lending conditions at financial institutions had been tight for five consecutive quarters, but positive economic growth and a gradual rescinding of perceived risk are expected in the coming loan officer survey for the fourth quarter. The Bank of Canada is anticipated to maintain its overnight target rate of 0.25% and its current policy of accommodation. [cee2f3f2]

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