Federal Reserve’s Financial Conditions Tighten: Evercore ISI Analysis

The Federal Reserve’s Tightening of Financial Conditions

If the Federal Reserve’s main policy goal these days is to tighten financial conditions, then it should be pretty close to achieving its goals, according to an Evercore ISI analysis. While the Fed is using its monetary levers directly to try to bring down inflation, officials measure their progress through the impact on a host of other metrics.

The Financial Conditions Impulse on Growth (FCI-G)

The Fed recently set up its own measure — the Financial Conditions Impulse on Growth (FCI-G) — to track the impact of their policies on various financial indicators. Evercore ISI expects the FCI-G to show that conditions have tightened substantially, evidenced by rising Treasury yields, as the central bank continues its rate-hiking campaign.

The Impact on the Economy

The recent surge in bond yields has pushed up mortgage and corporate borrowing rates, contributed to the fall in stock prices, and generated upward pressures on the dollar. Evercore ISI estimates that the shift in conditions will exact a 0.76 percentage point drag on GDP growth over the next year. This could convince Fed officials that they’ve done enough to slow the economy and bring down inflation.

No Need for Additional Interest Rate Hikes

If the projections are accurate, they could mean that no additional interest rate hikes are needed, even if cuts aren’t forthcoming. The unexpected tightening in financial conditions would likely lower the pressure on the Fed to deliver another 25 basis point rate hike and argues against signaling such a move in September. Market pricing supports this, with traders assigning only a 37% chance of a rate hike in November.

Economic Data and Inflation Concerns

Economic data has been stronger than expected lately, challenging the narrative of a halt in rate hikes. The Citi Economic Surprise Index recently hit its highest level in more than two years, indicating that current expectations are too low. Additionally, the Cleveland Fed’s inflation forecasting model is pointing to a 0.8% rise in the consumer price index for August, well above the central bank’s 2% goal.

Implications for the Fed

While further upside surprises could challenge the base case, the Evercore strategists believe that the tightening of financial conditions will “raise the bar” for an additional rate hike. They expect the Federal Reserve to move gradually and carefully on hold over the balance of the year.

(Source: Evercore ISI analysis, CME Group data)

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