Deciphering Some Mumbo Jumbo by the Fed
“The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market.” Federal Reserve Chairman Ben Bernanke, Sept. 18
“Currently, improving economic fundamentals versus fiscal drag and somewhat tighter financial conditions are pulling the economy in opposite directions, roughly canceling each other.” New York Fed President Bill Dudley, Sept. 23
“No, financial conditions have not tightened. Really.” MKM Partners’ chief economist Michael Darda, Sept. 17
What exactly are financial conditions, why is everyone talking about them, and who’s right about whether they are tightening?
Financial conditions, which statisticians like to express in an aggregate index, are a reflection of liquidity and risk in credit, equity and money markets. They are an indicator of the availability and cost of credit.
Different indexes have different components, but interest-rate spreads are a common feature: for example, the spread between a risk-free Treasury rate and the yield on a BAA-rated corporate bond; the TED spread between three-month Treasury bills and three-month eurodollars; even intramarket spreads, such as the one between a short- and long-term Treasury security.
What’s important isn’t the level of interest rates but the difference between a risk-free rate and what a bank, corporation or municipality would have to pay to borrow.
OK, end of lesson. Back to our story.
Fed officials have been warning about tighter financial conditions ever since long-term interest rates started to surge in May. At his news conference last week, Bernanke made several references to tightening financial conditions, including the quote at the beginning of this column. Many analysts said they were an important factor in the decision not to pare asset purchases at this time.
MKM’s Darda seems to have anticipated both Bernanke and Dudley, explaining in a Sept. 17 report why their assessment of financial conditions is incorrect.
“The stock market is up more than 25 percent since yields bottomed in July 2012, the yield curve has steepened and credit spreads have narrowed,” Darda said in a phone interview. “I don’t know how anyone gets a tightening of financial conditions out of that. You don’t even need an index.”
He’s right. During the entire period of rising long-term rates, financial conditions have gotten looser, according to the U.S. Bloomberg Financial Conditions Index (BFCIUS) (higher is looser), the Chicago Fed’s National Financial Conditions Index (lower is looser) and various other indexes. One might be tempted to conclude that the Fed is talking about 30-year mortgage rates and “using the cloak of financial conditions to disguise it,” Darda said.
Dudley specifically mentioned mortgage rates as a drag on the economy in a speech this week. Those rates rose from 3.35 percent for a 30-year loan in May to 4.5 percent last week, according to Freddie Mac, and like all prices, they are affected by both supply and demand. Yet when it comes to interest rates, people get funny in the head and draw conclusions from the price alone.
If rising long-term rates are such a drag, why is a steeper yield curve a harbinger of stronger growth? The New York Fed, the bank Dudley heads, devotes an entire section of its website to the yield curve as a leading indicator. The steeper the slope between a Fed-pegged overnight rate (or a short-term T-bill rate under the influence of the Fed) and a market-determined -- at least under normal circumstances -- long-term rate, the more expansionary monetary policy is. On the other hand, an inverted curve, with short-term rates higher than long rates, is a recession signal. And no, it wasn’t different that time when the curve inverted in mid-2006.
Former New York Fed economist Arturo Estrella, now a professor at Rensselaer Polytechnic Institute in Troy, New York, did a good deal of research on the subject, so I called him to get his thoughts on tightening financial conditions.
“A tightening of financial conditions comes from the Fed and regulators,” Estrella said. “The Fed can withdraw liquidity,” which it hasn’t done. “As a regulator of financial institutions, it can make banks tighten lending standards,” which they have been easing. “But the idea that financial conditions are tightening independently?” He didn’t need to answer his own question.
The spread between the funds rate and the yield on the 10-year Treasury note is one of 10 components of the Index of Leading Economic Indicators. It’s in there by design. The spread is the leading-est of the leading indicators. And it’s one reason the Fed’s effort to flatten the curve -- through outright asset purchases or by selling short-term bills and notes in exchange for long-term securities -- is ill-conceived.
The yield curve doesn’t come with a caveat attached: “to be used only in certain circumstances.” It is what it is. The mechanics aren’t difficult to understand. An upward-sloping curve is an inducement for banks to increase their earning assets and the money supply. Money and credit drive economic activity.
When the banking system is impaired, as it was in the early 1990s and again after the financial crisis, it takes a wider spread for a longer period of time to get the same effect.
Before the Fed starts acting on what it perceives to be tightening financial conditions, policy makers should consider the alternative. Would it really be a healthy sign, a reflection of easier financial conditions, if the 10-year yield collapsed to 1 percent?
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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