Fed’s tightening cycle challenged by easing financial conditions.

Fed's tightening cycle challenged by easing financial conditions.

Financial Conditions and the Possibility of Rate Hikes

Financial conditions play a crucial role in the decision-making process of the Federal Reserve. They affect the broader economy by transmitting changes in interest rates through the markets. Recently, several indicators have shown a slackening in financial conditions, prompting some experts to believe that the Fed may consider raising rates again before the end of the year.

Goldman Sachs’ Financial Conditions Index has been easing steadily since May, reaching levels last seen in late August of the previous year. Similarly, the Chicago Fed’s latest index also points to easier conditions. These shifts suggest that financial markets and the Federal Reserve may be starting to diverge on their paths.

“Easy financial conditions obviously boost near-term growth,” says Benson Durham, head of global policy at Piper Sandler, who believes that this can encourage risk-taking that goes against the restraint the Fed is trying to impose on the economy. This contrasting dynamic creates a complex situation for the central bank as it approaches the endgame of its tightening cycle.

The aim of the Fed’s historically aggressive campaign of short-term interest rate increases since March of the previous year was to tighten financial conditions and slow down the economy to lower inflation pressures. Mortgage rates have soared to around 7%, while other borrowing costs have also increased. These rate hikes had an impact on the stock market initially and pushed up the dollar against other currencies.

However, the recent slackening in financial conditions may pose challenges for the Fed. The various indicators show that financial conditions were most restrictive at the end of the previous year and have been receding since then. This coincides with a stock market rally that has pushed up the S&P 500 Index by nearly 20% so far this year. Additionally, yields on risky corporate debt securities have fallen even as the Fed continued raising interest rates.

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During a press conference following the Federal Open Market Committee meeting, Fed Chair Jerome Powell acknowledged the easier financial conditions but viewed them as a temporary situation that would, over time, align with the Fed’s goals. Powell stated, “We will do what it takes to get inflation down, and in principle, that could mean that if financial conditions get looser, we have to do more.” He suggested that financial conditions often fluctuate and eventually align with the Fed’s objectives.

Powell did not provide a clear indication of whether the Fed will raise rates or hold steady in September. Piper Sandler’s Durham believes that the current easier financial conditions increase the likelihood of another rate hike by the end of the year, in contrast to the market outlook. He suggests that this easing gives officials “the space and the breathing room” to raise rates again in an otherwise robust economy despite aggressive increases.

However, some analysts believe that the Fed may not need to hike rates again. Even though key aspects of the economy have remained strong in the face of higher rates, inflation pressures are easing. The latest government report showed a decline in inflation pressures last month and employment costs in the second quarter.

Bank of America analysts also noted that market pricing underestimates the necessary actions the central bank needs to take on rates. With easing inflation and strong job data, they argue that the Fed may worry about the insufficiency of its current policy stance.

In conclusion, the recent slackening in financial conditions has raised speculation about the possibility of the Federal Reserve raising rates again before the end of the year. While some indicators suggest this could happen, it remains uncertain as the Fed closely monitors various economic factors. The delicate balance between boosting growth and controlling inflation will ultimately guide the central bank’s decision-making process.

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