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Fed weighs benign impact of rate rises on markets

Among the arguments likely to be advanced in favour of an interest rate rise by the Federal Reserve at next week’s rate-setting meeting is a striking fact about its recent increases: they have left relatively little imprint on financial markets.

A gauge of financial conditions from Goldman Sachs shows that even after the 25 basis point rise in rates in March, financial conditions are more supportive of the economy than they were before, having since eased by 45 basis points. The two biggest drivers as of Friday were a fall in 10-year yields and a weaker US dollar. 

The benign backdrop in financial markets may counterbalance signs of soft economic growth and inflation when policymakers enter their deliberations on June 13 and 14, encouraging those calling for a rate rise. The Fed has sent a clear signal that it is ready to lift rates for a fourth time since the crisis started. But economic data have been disappointing, with jobs growth undershooting analyst expectations and core inflation hanging at 1.5 per cent — well below the 2 per cent target. 

Michael Feroli, an economist at JPMorgan Chase Bank, said the economy’s performance was not materially different from 2016, when the Fed kept rates on hold for most of the year, but financial markets have been less jittery than after the first rate rise. “Financial conditions are growth-supportive and that is a big reason why they are continuing to talk up more rate hikes,” he said. 

Financial conditions are tracked closely by senior rate-setters including Bill Dudley, the New York Fed president, who constructed a gauge when he was chief economist at Goldman Sachs. There are numerous measures in use alongside the Goldman variant, each tallying up factors such as equity prices, the dollar, and movements in yields to assess whether the financial markets are supporting growth or weighing against it. 

The St Louis Fed’s financial stress index has, for example, sagged to a three-year low, and at minus 1.54 points it is not far off the all-time low of minus 1.63 touched in August 2014. Its gauge consists of 18 factors, such as bond yields and interest rates, and is designed so that the average level — where market conditions are neither easy or tight — should be zero. 

Mr Dudley has been open in arguing that financial conditions should be taken seriously by the Fed. “I believe that my longstanding focus on financial conditions has, over time, helped me become a better economic forecaster,” Mr Dudley said in a speech this spring. “And, I am pleased that economists and analysts increasingly incorporate financial conditions into their assessments of the economic outlook.” 

Fed chair Janet Yellen © Getty

Other senior policymakers have also cited movements in markets in support of past changes in official rates. Before the Fed’s March rise, for instance, Stanley Fischer, the vice-chair of the Fed’s Board of Governors, said one of the factors weighing in favour of a tightening of policy was rising investor spirits demonstrated by surging asset prices. 

Ethan Harris, global economist at Bank of America Merrill Lynch, said part of the reason for the current benign financial conditions was the market’s view that a fiscal stimulus from the Trump administration was becoming less likely; this has had an impact on the bond market and the dollar, which has softened. 

The fading stimulus prospects are likely to weigh on some Fed policymakers’ deliberations, given around half of them had plugged some support from easier fiscal and regulatory policy into their outlooks back in December. But the flipside to that is a financial market backdrop that should stimulate growth. 

Mr Harris added that whereas one of the reasons for the Fed’s cautious approach to rate increases in the past two years had been fragile financial markets, the backdrop was now looking more robust. “It looks like markets are giving them a free pass to hike right now and it is one reason they are likely to go at the meeting,” he said. 

While markets may be buoying the economy, the Fed does not yet appear to believe there is stability-menacing exuberance on Wall Street. But it does appear to be watching certain areas closely. The minutes to the Fed’s May rate-setting meeting, for instance, noted that commercial property prices were strong in some sectors and that a sharp decline could pose a risk to financial stability. 

Lael Brainard, one of the Fed’s governors, said last week that risks in the financial system were not “flashing red” but that she was carefully watching high corporate debt levels as well as lax auto lending to borrowers with weaker credit histories. 

Jim Caron, bond fund manager at Morgan Stanley Investment Management, said the US had arrived at a unique part of the cycle, where there had been three rate increases plus the announcement of plans to start shrinking the Fed’s $4.5tn balance sheet, and yet financial conditions have become more supportive. 

“Financial conditions are easy enough for them to feel comfortable raising rates twice this year,” he said “They’re on a mission to get Fed funds [rate] to 3 per cent, and it will be hard to push them off course.”