There’s something of a ritual performed each time Federal Reserve Chair Jerome Powell speaks to the press: A reporter asks Powell about financial conditions; he says they’ve tightened a lot; the Wall Street crowd snickers.
To them, the notion seems ludicrous. Notwithstanding the selloff the past few weeks, markets have rallied in start-and-stop spurts for four months, swelling equity valuations and making it easier for companies to raise cash in stock and bond markets. The implication is that the Fed is letting investors undermine its efforts to choke off the flow of money and tame inflation.
So why such wildly different conclusions?
The answer has a lot to do with the way each side defines financial conditions. Investors tend to look at indexes created by the financial community. Goldman Sachs Group and Bloomberg LP, the parent company of Bloomberg News, have popular ones. There’s a certain high-finance flair to them. The gap between corporate and Treasury bond rates plays a big role in each. So does the VIX, a measure of stock market volatility, in the Bloomberg gauge.
The Fed, it would appear, keeps it a lot simpler. Lael Brainard provided a window into policy makers’ thinking on the topic last month in her final speech as Fed vice chair. In unveiling evidence of tightening financial conditions, she cited, among other things, the two-fold surge in mortgage rates over the past year as well as the fact that short-term interest rates are now higher than inflation.
Her message was clear: The Fed focuses a lot more on the one variable it controls in determining financial conditions — benchmark interest rates — and a lot less on the things that traders control. Put differently, the Fed doesn’t seem to worry about what happens on Wall Street as much as Wall Street thinks it does.
“Powell doesn’t really care whether the stock market is up or down,” says Bob Elliott, who co-founded Unlimited Funds in New York after a 13-year career at Bridgewater Associates. This, he says, is crucial for traders to understand. Some will bail out of stocks early in a rally out of misplaced concern that the gains are alarming Fed officials. The level of the stock market, “unless at extremes, is not particularly relevant to Fed policy.”
There was a time that Fed officials paid more attention to markets. This was the result in part of William Dudley’s arrival at the Fed.
A long-time economist at Goldman Sachs, he was one of the creators of the firm’s financial conditions index. When he scored the top job at the Fed’s New York bank in 2009, he brought that eye-on-markets approach inside the Fed boardroom.
Several regional Fed banks — Kansas City, Chicago and St. Louis — would go on to create similar gauges of their own that factor in moves in stocks, bonds and a bunch of obscure data points: commodity price volatility, open interest in stock markets and the cross-sectional dispersion of bank stock returns.
These sorts of markets-heavy indexes were particularly helpful in analyzing financial conditions back then. This was in the aftermath of the global financial crisis and the Fed had its benchmark rate pinned near zero for years.
With no big movements in broader rates to affect the economy, the more subtle financial developments captured by the indexes — like, for instance, a sudden jump in the spread between yields on junk bonds and Treasuries — had an outsize importance. The gauges were also hard-wired to sound the alarm about the potential for any new trouble brewing in the financial system.
Fed officials do, of course, still care to a certain degree about markets. There was a line tucked into the minutes from this month’s meeting, during which the Fed raised its benchmark rate for the eighth straight time, that suggested some board members were monitoring the recent gains in markets. While financial conditions remain “much tighter” than a year ago, these members said, it’s important that they be “consistent with the degree of policy restraint that the Committee is putting into place.”
But, in general, the indexes seem to have been relegated to second or third-tier status.
Brainard, who’s left the Fed to become President Joe Biden’s top economic adviser, made no mention of them in her speech last month. Powell has mostly spoken in generalities when the topic of financial conditions has come up. When he’s gotten into nitty-gritty specifics, though, he’s tended, like Brainard, to home in most on where benchmark rates stand vis-a-vis inflation.
“If you’re looking at all these measures, you say, ‘What is Powell looking at? It doesn’t make any sense, none of these indicators show that,’” says Steve Sosnick, chief strategist at Interactive Brokers. “But at their most basic level, monetary conditions are tighter than they were last year.”
