The Fed raised rates in September, and yesterday held rates steady, saying more information would help determine its next policy move.
You might expect broader financial conditions to tighten, too. But the Fed sets one rate. Treasury yields, credit spreads, and stocks are all trading on their own interpretation of what the Fed really meant.
Fed Chair Warsh has repeatedly said he was “hard pressed to describe broad financial conditions as restrictive.” That assessment helped frame the Fed’s September decision to remove “a dose of accommodation” with a 25-basis-point rate hike, its first since July 2023.
(That’s an interesting phrase. Usually when someone offers you a dose of something, you don’t expect U.S. Treasury yields to be involved.)
But the important point is that the Fed controls the policy rate. Financial conditions depend on considerably more than that, including Treasury yields, corporate credit spreads, equity prices, volatility and the dollar.
Timing matters, too. Markets can react to rate decisions in minutes, but the broader economic effects can take a year or more. It’s a little early for a retrospective.
So how do we determine whether financial conditions are actually tight?
There are quite a few indexes for tracking financial conditions, because Wall Street has never seen a question it couldn’t turn into a suite of products. We’ll look at four of the more common ones.
The Bloomberg U.S. Financial Conditions Index currently points to relatively easy conditions. Low VIX readings and equity-market performance have helped, along with credit measures including the Baa/10-year U.S. Treasury spread and high-yield option-adjusted spreads.
Then there’s the Goldman Sachs U.S. Financial Conditions Index, which combines the policy rate, long-term U.S. Treasury yields, corporate credit spreads, equity prices, and the trade-weighted dollar. Each component is weighted according to its estimated impact on real GDP growth over the following year.
(At this point, you may be wondering why we’re looking at four indexes. Don’t worry. We’re only halfway through.)
The Chicago Fed National Financial Conditions Index takes a broader approach, combining 105 indicators across three subindexes: risk, credit, and leverage. Risk captures volatility and funding risk, credit reflects credit conditions, and leverage incorporates debt and equity measures.
You might say, “Surely indicator 94 isn't pulling its weight.” But that's why you don't work at the Chicago Fed.
All three subindexes were negative as of October 23, signaling easier-than-average conditions.
Finally, we have the Fed’s Financial Conditions Impulse on Growth (or FCI-G). It asks a slightly different question: Are financial conditions helping or hurting economic growth? It incorporates changes in interest rates, equity and house prices, and the dollar over the preceding three years to estimate their impact on GDP growth over the next year. A positive reading indicates a headwind to growth; negative readings indicate a tailwind. Its August 31 reading was negative.
So, after four indexes, 105 indicators, and enough acronyms to open a small government agency, we have arrived at our conclusion: Financial conditions look relatively easy. We probably could’ve mentioned that earlier.
Here’s what actually matters: for investors, the important question isn’t simply whether financial conditions are easy or tight; it’s why. Rising stocks, calm markets, lower interest rates, and narrower credit spreads can all make financial conditions look easy. But they don’t all have the same effect on growth.
That’s where these indexes can be helpful. Not as standalone investment signals, but as different ways of understanding how monetary policy and financial markets may be feeding through to the economy.
Which means the Fed can raise rates while broader financial conditions remain relatively easy.
See? Simple.
We just needed 105 indicators to explain it.
Advisor angles
These following talking points can prepare you for questions about why a Fed rate hike doesn’t always mean tighter financial conditions.
The Fed raised rates. Doesn’t that mean financial conditions are getting tighter?
Not always. The Fed sets its own rate, but markets set other borrowing costs. If those costs fall or stocks rise, financial conditions can stay easy even after a rate hike.
Does this mean the Fed’s rate hike isn’t working?
Not necessarily. Rate hikes take time to affect borrowing, spending, and the broader economy. These indexes show overall financial conditions, not how much of a difference a single Fed decision made.
Why look at several financial conditions indexes?
They measure different things. Some compare today’s financial conditions with the past. Others estimate how those conditions may affect economic growth. Together, they give a fuller picture than one index alone.
If all these measures say conditions are easy, what does that tell us?
It suggests that financial conditions can stay easy even when the Fed raises rates. The Fed’s rate is only one part of what shapes conditions across markets and the economy.
Are easier financial conditions good for economic growth?
They can be. The Fed’s FCI-G index estimates whether financial conditions are helping or slowing economic growth. The reading discussed here suggested they were helping.
What could cause financial conditions to tighten?
Changes in interest rates, U.S. Treasury yields, credit spreads, stock prices, market swings, and the dollar can tighten financial conditions. That can happen even if the Fed leaves its rate unchanged.
Source: Bloomberg, Federal Reserve Bank of Chicago, Federal Reserve, Goldman Sachs