Photographer: Andrew Harrer/Bloomberg

Goldman Sachs: Financial Conditions Have Gone From a Headwind to a Tailwind for the U.S. Economy

How times have changed.

Remember when financial conditions were poised to serve as a drag on U.S. growth? Or when the equivalent of three interest rate hikes had been delivered before the Federal Reserve even went through with liftoff?

Well times have changed, according to Goldman Sachs Group Inc. Chief Economist Jan Hatzius.

In fact, Goldman Sachs's Financial Conditions Index (FCI), which tracks equity prices, the U.S. dollar, Treasury yields, and credit spreads, has declined to levels seen in August—right before markets were roiled in the wake of the devaluation of the Chinese yuan:

Source: Bloomberg

The thinking here is that tighter financial conditions crimp corporate borrowing, net exports, and consumer spending, while looser financial conditions are conducive to the reverse.

"This round trip in the level of the FCI implies a sharp improvement in the change in the FCI, a key short-term driver of the business cycle," wrote Hatzius.

This exercise shows how quickly sentiment can change in markets, as well as the difficulty of making forecasts—or setting monetary policy—based on financial conditions that can prove fleeting.

Critics might argue that the Fed overreacts to non-persistent price action. On the other hand, perhaps it was the U.S. central bank's change of heart that laid the groundwork for this improvement in financial conditions, helping to spark a widespread market rally.

The jury's still out on that front.

Hatzius asserted that some of the lackluster U.S. data over the past few quarters should be seen through the prism of these financial headwinds. The lagged effect of this improvement in financial conditions, if enduring, should be a net benefit for economic growth to the tune of about 0.25 percentage points in 2017—a huge swing from recent history:

Source: Goldman Sachs

"In practice, this calculation is likely too positive," concluded Hatzius, who thinks that the Fed will hike rates on a quicker timetable than markets are currently pricing in. "Nevertheless, we think financial conditions have turned from a significant downside risk to our growth forecast in early 2016 to a moderate upside risk at present."

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