The Fed, perception and reality

At its March meeting, the Fed increased the key federal funds rate (FFR) by 25 basis points (bps), bringing it into the 0.75 per cent to 1.00 per cent range.

According to the Fed, the increase was "…viewed as appropriate in light of the further progress … made toward the Committee's objectives of maximum employment and 2 per cent inflation."

The move was largely in line with the market’s expectations although perhaps a little early. More surprising was the central bank’s dovish tone. The Fed continued to emphasise the gradual nature of its expected rate hikes as it looks for a level of 3 per cent in three years’ time. Two more hikes are anticipated in 2017.

ARE CONDITIONS ACTUALLY TIGHTENING?

So while the FFR is 75 basis points higher than December 2015, does this mean financial conditions are actually tightening?

When we talk of financial conditions for the economy we mean the cost and availability of finance. It’s more than just the level of one particular interest rate and this is complex to measure as there are numerous ways for companies, households and governments to fund spending.

In the US, the Chicago Federal Reserve Bank combines a range of financial variables to provide the National Financial Conditions Index (NCFI).

History shows a level of 0 or higher is typically consistent with a period of recession. At its current level of (-0.8), it’s consistent with continued strong economic growth.

Since the Fed started tightening over 12 months ago, the NCFI suggests financial conditions have eased, not tightened. So what gives?

While financial conditions have eased, the Senior Loan Officer Opinion Survey on Bank Lending Practices (SOSLP) is somewhat tighter and broadly neutral in contrast to financial conditions, which have remained as accommodative as possible.

This has happened before – in both the 1990s and 2000s cycles. Each time financial conditions eventually tightened in line with the SOSLP.

NOT FOR THE FIRST TIME

Last decade we saw a similar situation when higher short-term interest rates didn’t follow through to tighter financial conditions.

Looking back at the period between 2004 and 2007, New York Fed President William C. Dudley argued the Fed “wasn’t really effective in tightening conditions, so (it) didn’t really achieve its objective”.

He also went on to say “this was probably a period where the Fed should have done a bit more”.  

So, although the Fed was steadily raising rates, it still wasn’t tightening overall financial conditions. How can this be the case?

Significantly, the Fed’s gradual tightening was well telegraphed and it gave no sign it was interested in really slowing down the economy. Therefore markets reacted positively.

This was evident in the tightening spread between high-yield (high-risk) and low-risk government bond yields.

The market’s perception of a falling risk environment resulted in credit being made readily available. Credit conditions didn’t tighten until 2008 as signs of a bursting US house price bubble became evident and risk began to be priced in again.

Financial conditions being too easy for too long led to what we now know as the Global Financial Crisis (GFC).

CONTRAST

This episode stands in contrast to the 1990s cycle when financial conditions did tighten due to a Fed rate hike cycle.

While the US economy did end up in recession, it was relatively mild, with the unemployment rate rising by 2.5 per cent versus the 6 per cent of the 1980s recessions.

This suggests it’s better to take the ‘medicine’ early (ie tighter interest rates) rather than delay it – a case of being cruel to be kind.

Will the Fed tightening we see now be enough to prevent the current cycle ending in tears? First of all, it’s still early days.

In the past, the Fed has been compared to the killjoy who removes the punch bowl just as the party is getting started.

The Fed’s slow reaction this time reflects low inflation and wages growth in the US, Europe and Japan, along with modest growth in debt outside of the government sector. The deflationary and deleveraging forces of the GFC live on although there are signs these are fading.

The simple message is if the Fed needs to tighten financial conditions there is still quite a bit of work to do.

The US is undoubtedly sitting in a place we’d normally characterise as late in the business cycle but it continues to have very accommodative financial conditions.

Efforts by the Fed so far in raising rates have (if anything) seen financial conditions ease. These moves have encouraged the market to believe the business cycle can be extended, supporting both share and debt markets.

For the moment, the Fed feels it can take its time due to the hangover of the GFC’s deflationary and deleveraging headwinds. We don’t expect this to change any time soon.

Mark Rider is Chief Investment Officer at ANZ Wealth