US Federal Reserve chairman Ben Bernanke said on September 18: “The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labour market.”
New York Fed president Bill Dudley said on September 23: “Currently, improving economic fundamentals versus fiscal drag and somewhat tighter financial conditions are pulling the economy in opposite directions, roughly cancelling each other.”
MKM Partners’ chief economist Michael Darda said on September 17: “No, financial conditions have not tightened. Really.”
What are financial conditions, why is everyone talking about them, and who’s right about whether they are tightening?
Financial conditions, which statisticians like to express in an aggregate index, are a reflection of liquidity and risk in credit, equity and money markets. They are an indicator of the availability and cost of credit. Different indices have different components, but interest rate spreads are a common feature: for example, the spread between a risk-free treasury rate and the yield on a BAA-rated corporate bond.
What’s important isn’t the level of interest rates but the difference between a risk-free rate and what a bank, corporation or municipality would have to pay to borrow.
OK, end of lesson. Back to our story.
Fed officials have been warning about tighter financial conditions since long-term interest rates started to surge in May. At his news conference, Bernanke made several references to tightening financial conditions, including the quote at the beginning of this column. Many analysts said they were an important factor in the decision not to pare asset purchases at this time.
MKM’s Darda seems to have anticipated Bernanke and Dudley, explaining in a September 17 report why their assessment of financial conditions is incorrect.
“The stock market is up more than 25 percent since yields bottomed in July 2012, the yield curve has steepened and credit spreads have narrowed,” Darda said. “I don’t know how anyone gets a tightening of financial conditions out of that. You don’t even need an index.“
He’s right. During the entire period of rising long-term rates, financial conditions have got looser, according to the US Bloomberg financial conditions index (higher is looser), the Chicago Fed’s national financial conditions index (lower is looser) and various other indices. One might be tempted to conclude that the Fed was talking about 30-year mortgage rates and “using the cloak of financial conditions to disguise it”, Darda said.
Dudley specifically mentioned mortgage rates as a drag on the economy in a speech last week. Those rates rose from 3.35 percent for a 30-year loan in May to 4.5 percent a week ago, according to Freddie Mac, and like all prices, they are affected by both supply and demand. Yet when it comes to interest rates, people get funny in the head and draw conclusions from the price alone.
If rising long-term rates are such a drag, why is a steeper yield curve a harbinger of stronger growth? The New York Fed, the bank Dudley heads, devotes an entire section of its website to the yield curve as a leading indicator. The steeper the slope between a Fed-pegged overnight rate (or a short-term T-bill rate under the influence of the Fed) and a market-determined – at least under normal circumstances – long-term rate, the more expansionary monetary policy is. On the other hand, an inverted curve, with short-term rates higher than long rates, is a recession signal. And no, it wasn’t different that time when the curve inverted in mid-2006.
The spread between the funds rate and the yield on the 10-year treasury note is one of 10 components of the Index of Leading Economic Indicators. It’s in there by design. The spread is the leading-est of the leading indicators. And it’s one reason the Fed’s effort to flatten the curve – through outright asset purchases or by selling short-term bills and notes in exchange for long-term securities – is ill-conceived.
The yield curve doesn’t come with a caveat attached: “to be used only in certain circumstances”. It is what it is. The mechanics aren’t difficult to understand. An upward-sloping curve is an inducement for banks to increase their earning assets and the money supply. Money and credit drive economic activity.
When the banking system is impaired, as it was in the early 1990s and again after the financial crisis, it takes a wider spread for a longer period of time to get the same effect.
Before the Fed starts acting on what it perceives to be tightening financial conditions, policymakers should consider the alternative. Would it really be a healthy sign, a reflection of easier financial conditions, if the 10-year yield collapsed to 1 percent?
Caroline Baum, the author of Just What I Said, is a Bloomberg View columnist.