Are financial conditions tight or loose? Depends who you ask

Goldman Sachs' financial conditions index (FCI) says conditions have tightened sharply, thanks to high borrowing costs and a strong dollar. The Chicago Fed's National Financial Conditions Index says they are still looser than the historical average, because credit spreads are narrow and equities have held up. Ask a macro hedge fund manager whether money is tight or loose, and the answer depends on which index gets consulted.

Why central banks watch conditions

Monetary policy works mostly through markets, not directly through the overnight rate the Fed sets. A change in the policy rate matters because it moves the prices that households and companies actually face: mortgage and corporate borrowing costs, the value of shares and homes, the exchange rate and the willingness of lenders to extend credit. A financial conditions index tries to condense all of these into a single number. If the index shows conditions tightening, policy is working; if it shows them easing despite higher rates, the Fed's efforts are being offset.

Two gauges, two answers

The disagreement matters, because it sits at the centre of the argument over monetary policy. If conditions are already choking the economy, the Fed has finished tightening. If tight high-yield spreads and buoyant equity markets mean conditions are easy, policy has not yet taken proper hold. Policymakers have to decide whether they are pushing against tightening that is already happening, or letting speculative excess rekindle inflation.

The weighting problem

The two indices disagree because they are built differently. Goldman's index combines a small number of market prices, including short- and long-term interest rates, corporate credit spreads, equity prices and the trade-weighted dollar, weighted by their estimated effect on economic growth. Interest rates and the dollar carry a heavy weight, so the surge in Treasury yields and the strength of the dollar this year show up as sharp tightening. The Chicago Fed's index draws on more than a hundred indicators of risk, credit and leverage across money markets, debt and equity markets and the banking system, and expresses the result relative to its long-run average. Because spreads are narrow and funding markets are functioning smoothly, it reads as easier than normal.

Neither index is wrong. They answer different questions. Goldman's is closer to asking how much the price of money has changed and what that implies for growth. The Chicago index is closer to asking whether the financial system is under stress. A market in which borrowing is expensive but freely available can register as tight on one and loose on the other.

The equity component adds another distortion. American stock indices are increasingly dominated by a handful of very large technology companies, so a rally in their shares can register as a broad easing even when most smaller listed firms have seen little benefit. Those giants fund themselves largely from their own cash flows, so their higher share prices say little about the cost of capital for the typical borrower.

A moving target

The readings have also swung sharply in recent weeks. In October, with the ten-year Treasury yield close to 5 per cent and equities falling, conditions tightened on almost every measure, and several Fed officials said the rise in long-term yields might do some of the committee's work. Since then yields have tumbled, with the ten-year back to around 4.45 per cent after softer inflation and job figures, and stocks have rallied strongly. Much of the tightening that officials cited has already reversed.

Greenspan's conundrum

The Fed has faced this problem before. Between 2004 and 2006 it raised its policy rate steadily, yet long-term Treasury yields barely rose and mortgage rates stayed low, a pattern Alan Greenspan described as a conundrum. Financial conditions for homebuyers remained easy even as policy tightened, and the housing boom continued until it collapsed. The episode taught officials that the policy rate alone is a poor guide to how tight money really is, and that markets can offset a central bank's intentions for long periods.

Who benefits from the confusion

The ambiguity favours borrowers with access to capital markets. Large companies with investment-grade ratings can issue bonds at spreads that are narrow by historical standards, and equity investors are once again willing to pay high multiples for growth. Smaller firms that depend on bank loans face a different world, since banks have tightened lending standards after this year's regional-bank failures. The same economy can be easy for some borrowers and tight for others, which is part of why the indices disagree.

The case for looking through the gauges

Some economists argue that the Fed should pay less attention to financial conditions and more to the real economy, since what matters in the end is inflation and employment. Inflation has fallen, unemployment has edged up to 3.9 per cent, and the Fed's own projections show rates staying above 5 per cent through most of next year. On that view the debate over indices is a sideshow. The difficulty is that financial conditions move first, and by the time their effects appear in the real economy it can be too late to respond.

The indicators to watch are credit spreads on high-yield bonds, the Chicago Fed's weekly index, the ten-year yield and the dollar, and whether Fed officials at their meeting in mid-December describe the recent rally as a concern.

Rival indices giving opposite readings show how hard central banking has become. The Fed cannot set policy precisely when economists cannot agree whether money is tight or loose, and it will probably err towards holding rates high for longer, keeping its policy rate unchanged well into next year.