Confidence. Who couldn't use a bit more of it? That's true whether you're a job candidate entering a final-round interview, a baseball player stepping into the batter's box, or a Federal Reserve official on the lookout for signs that inflation is on a sustainable downward trajectory toward a 2% annual rate.
Unfortunately, confidence about cooling inflation is in short supply this year. Uncomfortably high price growth is sticking around longer than expected, economic growth continues apace, and there's no good cause for the Fed to lower interest rates in the near term, as numerous Fed officials, including Fed Chair Jerome Powell, recently have suggested.
Futures markets have moved to price in fewer rate cuts by the Fed in 2024, and some economists have even posited that the central bank won't cut rates until 2025.
What's behind inflation's resilience? Loose financial conditions across the economy look to be one culprit, notwithstanding the insistence of Powell and other central bank officials that policy is restrictive.
By the numbers, they might be right: The so-called Taylor Rule, introduced by Stanford economist John Taylor in a 1993 paper, prescribes a current federal-funds rate target of around 4.75%, based on recent inflation and economic growth figures. That's lower than the Fed's current target range of 5.25% to 5.5%, and marks the first time in a decade that policy has been in restrictive territory by this measure, except for a brief period in 2020 when even a 0% fed-funds rate was restrictive for an economy in pandemic lockdown.
That's only in theory, however. In practice, real-world measures of financial conditions are solidly in easy territory today. The Chicago Fed's National Financial Conditions Index is as loose as it was in January 2022 -- two months before the Fed started increasing interest rates.
Updated weekly, the NFCI's 105 market- and survey-based inputs include bank lending standards; yield spreads on government, corporate, and mortgage bonds; levels of debt outstanding and new issuance; the U.S. dollar index; and, importantly, the level of the stock market.
The Fed directly controls only one of those factors, however, namely interest rates. Every corporation with a competent chief financial officer refinanced and termed out their debt before the Fed began increasing interest rates in 2022. Millions of homeowners are sitting on 30-year mortgages fixed at rates lower than what they're earning on their savings accounts. Solid earnings growth and excitement over artificial intelligence have pushed stock indexes to record highs. A structural shortage of housing in the U.S. is keeping home prices aloft.
The mere fact that the fed-funds rate is well above 5% doesn't tell the full story in the context of looser financial conditions practically everywhere else.
"We can't help but think that this massive loosening in financial conditions makes it a lot less likely that the data is going to do what the Fed is looking for in terms of weakening labor markets and lower inflation," write Jefferies strategists.
One area where conditions aren't so loose? Private markets such as venture capital. VC funding fell in 2023 to levels even below the pandemic-era 2020 low, according to data from Termina. It has moved sideways since then. "The flow of capital is stabilizing," says Arjun Sethi, Termina's co-founder. "But the companies getting funding today tend to be more stable businesses with clear paths to profitability."
That's probably a healthy shift, from the growth-at-any-cost days of 2021 and 2022 when investors would write checks first and ask questions later.
Elsewhere, the backdrop is more supportive: first-quarter corporate-bond issuance hit a record high, according to Bloomberg. "Easy financial conditions continue to provide a significant tailwind to growth and inflation," says Torsten Sløk, chief economist at Apollo Global Management. "As a result, the Fed is not done fighting inflation and rates will stay higher for longer."
Sløk expects no rate cuts in 2024. After another month or two of strong inflation and growth data, the market might move to price in a similar view. That could mean higher bond yields -- and lead to a tightening in financial conditions.
There's another, more technical reason to expect tighter financial conditions later in 2024, says David Page, head of macroeconomic research at AXA Investment Management. Over the past year, the Fed's overnight reverse repurchase facility, or RRP, has been declining -- adding cash to the banking system faster than quantitative tightening, or QT, has been pulling it out. That means liquidity has still been flowing, supporting borrowing, credit markets, and financial conditions.
The central bank is allowing $60 billion in Treasuries and $35 billion in mortgage-backed securities to mature monthly, without reinvesting the proceeds. The overnight RRP balance dipped below $400 billion last week, from around $2.4 trillion a year earlier -- decreasing by some $167 billion per month, on average. At the current pace the facility will be depleted around the end of June.
And at that point, QT will begin coming directly out of bank reserves, draining liquidity from the system. That's a reversal of the past year's dynamic and will be a headwind for risk assets of all kinds, Page says.
But Fed officials know it's coming and have begun discussing slowing the pace of QT. A plan could come as soon as at the policy meeting that ends May 1. For now, though, "this is just not an environment in which the Fed needs to be cutting for liquidity reasons," says Josh Emanuel, chief investment officer at Wilshire.
How's that for confidence?
