In its latest weekly Economic Indicators Update, Goldman charts the ongoing paradoxical divergence between the Fed's professed tightening path and what is actually taking place in the US stock market, where it finds that financial conditions are the easiest they have been in two years.
One month ago, Goldman discussed this topic in depth when Jan Hatzius implicitly asked if Yellen has lost control of the market, and warned that in order to normalize fin conditions, the Fed may be forced to follow through with a "policy shock."
Overnight, Deutsche Bank also focused on the ongoing divergence between Fed intentions and market reality, noting that despite another weak Q1 for US growth and several soft inflation prints in recent months, "the Fed has for the most part stuck to the script for policy over the remainder of the year." The German bank notes "recent communication has continued to signal that at least one rate hike – the first likely coming at next week's June FOMC meeting – and a reduction in the balance sheet are still likely by year-end." It posits one reason why the Fed has remained on message "is that financial conditions have persistently eased despite two rate hikes since December. In fact, our financial conditions index has recently neared the loosest (i.e., most supportive of growth) levels since 2014."
We consider these questions through the lens of our financial conditions index (FCI). In brief, our high-frequency FCI is a composite of various financial market indicators – the trade-weighted dollar, equities, the 10-year Treasury term premium, VIX, mortgage spread, and corporate bond spread. The variables are transformed when needed (e.g., by taking growth rates), standardized by their pre-crisis mean and standard deviation, and then aggregated into an index using weights based on each variable's historical relative ability to forecast out-ofsample real GDP growth. The index is constructed such that positive values indicate that financial conditions are supportive of growth, while negative values are consistent with tight financial conditions that exert a drag on growth.
It's not just DB's (and Goldman's) own calculations that reveal an easing in financial conditions:
"The supportive trend in financial conditions evident in our FCI is not dependent on the methodology we use to construct our index. Indeed, the signals from various alternative FCIs – including from Bloomberg and the Chicago, Kansas City and St. Louis Federal Reserve Banks – are similar: financial conditions have eased materially in recent months even as the Fed has raised rates."
So the next question, as asked by Goldman one month ago, is "what does this easing mean for the Fed?" Here is DB's answer:
One way to approach this question is to translate the move in our FCI into a "fed funds equivalent." We do this by comparing the GDP implications from recent changes in our FCI – based on a regression of real GDP growth on our FCI with lags – to the impact of Fed rate hikes on real GDP growth. To pin down the latter, we use simulations from the Fed's model of the US economy (FRB/US) which suggest that a 100bp cut in the fed funds rate boosts real GDP growth over the coming year by about 0.5 percentage points.
Since the Fed raised rates in December 2016, our FCI has risen by about 0.35 index points. Based on a regression, this rise in the FCI would tend to add about 0.2 percentage points to real GDP growth during this quarter and in Q3, after which the impact on growth would dissipate. The boost to growth over the nex four quarters from this easing in financial conditions is equivalent to about one Fed rate cut of 25bp.
In addition to supporting the baseline near-term growth outlook, there is evidence that financial conditions provide important information about the risks around the outlook, with loose conditions reducing downside risks to growth.
Simply said, in terms of its impact on real GDP growth, the Fed's "tightening" since the December 2016 FOMC meeting is the equivalent to one 25bp rate cut, even though the Fed has raised twice over this period.
The conclusion: the divergence can't - and won't - continue, and "whether or not this easing of financial conditions persists as the Fed continues to raise rates and also begins to unwind its balance sheet will be an important factor in whether the market or the Fed view proves correct about monetary policy in 2018."