The Uneasy Dance Between the Markets and the Fed

The Optimism Problem

Yet this market exuberance, which has ebbed somewhat for the moment, amounted to a “loosening” or “easing” of “financial conditions.” It was, therefore, a source of consternation for the Fed, which has been trying to tighten financial conditions for more than a year now.

The minutes of the Dec. 13-14 meeting of Fed policymakers in the Federal Open Market Committee were revealing: “Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee’s reaction function, would complicate the committee’s effort to restore price stability.”

The idea is that by making it more expensive and more difficult to borrow money, the Fed can slow the economy — and squeeze rampant inflation out of it. But this isn’t a straightforward process. It happens through the very channels that showed signs of optimism — prematurely, from the standpoint of the Fed.

Two sets of measurements suggest what has been happening. First, a project at the Federal Reserve Bank of Chicago, which uses more than 100 indicators to come up with a National Financial Conditions Index for the overall economy, shows that financial conditions tightened — as the Fed wanted — through October. But even though the central bank persisted in raising the federal funds rate, conditions loosened through the latest reading of the index on Feb. 10.

Second, the Federal Reserve Bank of San Francisco’s Proxy Funds Rate — which uses an array of data to assess broader financial conditions on a monthly basis — shows a tightening of financial conditions through November, followed by a loosening in January and February.

The Labor Department’s monthly jobs report was perhaps the single biggest piece of good economics news of recent weeks. It suggested that instead of slowing in the face of repeated rate increases, the economy was surging. Hiring in the United States heated up in January, with the creation of 517,000 jobs on a seasonally adjusted basis.

Uh oh.

As Deutsche Bank put it in a research report, “Financial conditions have failed to tighten enough for the Fed to have confidence” that it is winning the inflation fight. Much more tightening may be necessary. The bank now expects the Fed to raise short-term rates nearly a full percentage point higher.