US Fed Tightening Financial Conditions? Not Really.

EranP Eran Peleg, Chief Investment Officer

US Fed Tightening Financial Conditions? Not Really.

 

The US unemployment rate recently dropped as low as 4.4%, below the US Federal Reserve's estimate of NAIRU (Non-Accelerating Inflation Rate of Unemployment), the unemployment rate consistent with stable inflation. Given that the US economy has gradually improved over the past few years and is now running at or near full capacity, the US Federal Reserve recently embarked on a process of interest rate hikes --  with the objective being to gradually tighten financial conditions in the face of a heating economy.

 

But the Fed is failing. Not only have financial conditions not tightened in recent months – they have actually eased considerably since the Fed resumed raising rates in December. Equity prices are higher, credit spreads are tighter and the dollar is weaker (after last week's fall, it is now down -5% on a trade-weighted basis since the start of the year). The Chicago Fed's index of national financial conditions tells the story:

 

Federal Reserve Bank of Chicago

 

Source: Federal Reserve Bank of Chicago

 

What are the implications? The Fed needs to do much more if it is aiming to tighten financial conditions and start gently putting the brakes on an economy operating at or near full capacity.