Market Boost to U.S. Economy Fades as Stress IncreasesMatthew Boesler
This summer, the U.S. economy enjoyed the easiest financial conditions of the post-crisis era. Those days are probably over.
Financial stress is rising, according to gauges maintained by the Federal Reserve Banks of Chicago and St. Louis, as well as measures compiled by Goldman Sachs Group Inc., Bank of America Merrill Lynch and Bloomberg.
The deterioration reflects tightening credit conditions for companies, higher stock-market volatility and a stronger dollar. Put those elements together, and the boost to the economy provided by financial markets is fading.
“We’re seeing financial conditions that are broadly supportive of growth, but pretty meaningfully less so than they were,” said Matthew Luzzetti, a New York-based economist at Deutsche Bank Securities Inc. With the Fed’s program of bond purchases winding down this month, the market’s focus shifting toward the prospect of Fed interest-rate increases and the dollar poised to continue rising, “all of those things probably point toward some tightening” of conditions going forward.
The 4.1 percent rise in the trade-weighted U.S. dollar since June 30 is a key reason for the less-accommodative landscape and could reduce U.S. economic growth by 0.2 percentage point during the next year, according to Jan Hatzius, chief economist at Goldman Sachs in New York.
The Goldman Sachs Financial Conditions Index was 99.55 on Oct. 10, up from a post-crisis low of 99.17 on July 1. Higher readings point to tighter conditions; it peaked at 102.96 during the recession.
In response, the Fed may push back the timing of its first rate increase since 2006 or raise rates more slowly once increases begin. Fed officials express growing concern about risks to the U.S. expansion posed by slowing overseas growth, which may reduce demand for American exports, along with a stronger dollar, which could keep a lid on inflation.
The central bank has held its benchmark federal funds rate near zero since 2008 to combat the effects of the worst recession in nearly 80 years. Most members of the policy-setting Federal Open Market Committee said at their September meeting that the first increase should come before the end of 2015 as the labor market improves.
“You could argue, with the unemployment rate at 5.9 percent, things are getting better. The economy is growing at 3 percent. The Fed or any central bank should be hiking rates very soon,” said David Woo, head of global rates and currencies at Bank of America Merrill Lynch in New York. “However, if the dollar is strengthening, that already leads to a tightening of monetary conditions,” which “makes higher interest rates less necessary.”
A silver lining is the 26 percent decline in oil prices since June, said Woo. Lower energy costs allow U.S. households to spend more on other goods and services, which is tantamount to an easing of financial conditions, he said.
So far, the two opposing forces have offset each other, Woo said, “but if oil prices don’t go much lower, I think the U.S. economy is going to struggle to watch and live with a much higher dollar.”
While lower oil prices may constitute a tailwind for the U.S. consumer, they’ve also contributed to market turmoil, which adds to financial stress. The Standard & Poor’s 500 Index fell 0.8 percent today. The index has fallen 7.4 percent since its 2014 peak on Sept. 18, with energy the worst-performing sector, down 14 percent.
The Chicago Board Options Exchange Volatility Index, derived from prices paid for options on the S&P 500, rose to 26.25, nearly double its 12-month average of 13.79. Higher volatility makes it harder for companies to raise capital and clouds the outlook for investment.
The moves sent the Bloomberg U.S. Financial Conditions Index below zero today for the first time in more than two years. Readings above zero reflect conditions that contribute to growth.
Against this backdrop, top Fed officials also fret about the cooling world economy. Fallout from weaker-than-anticipated global growth could prompt the central bank to defer an interest-rate increase, Fed Vice Chairman Stanley Fischer said in an Oct. 11 speech at the International Monetary Fund’s annual meetings in Washington.
Fed Governor Daniel Tarullo made similar comments the same day, saying the prospect of slower expansion worldwide is something “we have to think about in our own policies going forward.”
A stronger dollar poses headwinds to U.S. companies by making it harder for exporters to sell their products abroad. And with 46.3 percent of revenue for companies in the S&P 500 generated overseas in 2013, according to S&P Dow Jones Indices, a rising dollar reduces profits for large U.S. multinationals.
“The dollar appreciation is primarily driven by the fact that Europe and Asia are still pretty weak,” Hatzius said. The currency’s ascendance “is, in some sense, the vehicle through which the weakness in those places is being transmitted to the U.S.”
Dollar strength also may lead to a lower cost of imported goods, which in turn damps general price increases and contributes to falling inflation expectations.
This complicates the Fed’s efforts to return inflation to the central bank’s 2 percent target. The personal consumption expenditures price index rose 1.5 percent in August from a year earlier, marking 28 straight months below the goal.
Expectations for future price increases also have come down. A Bloomberg measure of the market’s forecast for the average inflation rate during the next five years has dropped 0.61 percentage point since June to 1.44 percent, and a Fed measure of expected average inflation for the five years starting five years from now is down 0.21 percentage point.
At 2.22 percent, the Fed measure is near levels that coincided with central-bank bond buying in 2008, 2010 and 2011. Policy makers watch this so-called forward break-even rate because it cuts through the noise of transitory price fluctuations.
The drop in forward inflation expectations may be signaling that the market believes “the Fed’s zeal to inflate the economy to get what they want might not be as great as some had thought,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. If expectations don’t head higher again, “it would be a problem, and I think it would be questioning the Fed’s credibility” with regard to its inflation target.
To push longer-term expectations up, the Fed could defer its first rate increase and temper the pace of increases thereafter, Hatzius said in an Oct. 6 telephone interview.
“We’re probably not quite at a point yet where such a response is clearly coming, but if we had, say, another 20-basis-point decline in some of these forward break-evens, I think then we would get some kind of a response.”