Just hours after the Fed’s March “dovish” rate hike, when stocks paradoxically surged to all time highs and yields tumbled, Goldman found something strange: “surprisingly, financial markets took the meeting as a large dovish surprise—the third-largest at an FOMC meeting since 2000 outside the financial crisis, based on the co-movement of different asset prices.” Even more surprising is that according to Goldman, its financial conditions index, “eased sharply, by the equivalent of almost one full cut in the federal funds rate.” In other words, the Fed’s 0.25% rate hike had the same effect as a 0.25% race cut!
Goldman’s Jan Hatzius then went on to note that this was “almost certainly not” the desired outcome that Janet Yellen had been going after, and that markets had in fact misread the Fed’s tightening intentions. The Goldman chief economist then asked rhetorically “how will the committee respond to this potentially undesired move” and answered “at the margin, it will likely make them more inclined to tighten policy. Using today’s estimated close, our FCI impulse model now implies a boost of about ½pp to real GDP growth in 2017, from a starting point of roughly full employment and inflation close to the target. So further FCI easing implies at least some risk of economic overheating—which in turn would increase the risk of recession further down the road. We expect the committee to lean against such an easing over time.”
Nearly two months later, with stocks at new all time highs, and financial conditions even easier than they were the first time Goldman warned that the market had misread the Fed’s intentions, Goldman goes back to this most sensitive of topics and writes that despite two rate hikes and indications of impending balance sheet runoff, financial conditions have continued to ease over the past six months.
Despite two rate hikes and indications of impending balance sheet runoff, financial conditions have continued to loosen in recent months. Our financial conditions index is now about 50bp below its November 2016 average and near the easiest levels of the past two years.
Hatzius then asks if – in not so many words – the Fed has lost control of the market, or if the Fed will simply have to punish the market with a “monetary policy shock” to make it clear that the Fed demands tighter conditions to delay the next recession. To wit:
Does this mean that 1) monetary policy has lost its ability to affect financial conditions or 2) Fed officials just need to deliver more rate hikes if they want to bring about an FCI tightening?
According to Hatzius, “the answer is 2)” and that the Fed has not lost control of the market just yet. Which brings up another question:
If the Fed retains its ability to steer financial conditions, why have financial conditions eased recently despite ongoing hikes? The answer is that Fed policy—especially Fed policy communicated around FOMC meetings—only accounts for a relatively small part of the ups and downs of financial conditions. And other developments such as the sharp pickup in global growth have been helpful for US financial conditions by boosting risk assets while keeping the US dollar from appreciating sharply in response to higher short-term interest rates. While it is difficult to say whether future non-monetary policy shocks will be positive or negative for US financial conditions, our finding that the impact of Fed policy on financial conditions remains (at least) similar to the longer-term average suggests that Fed officials should be able to achieve their goals for financial conditions by moving the funds rate if they try hard enough.
Fed Policy Retains Sizable Impact
What Goldman really meant to say is that the Fed’s 50 bps in rate hikes since December have been drowned and offset by the trillions in new credit created out of China. That credit expansion is now ending however, and China’s credit impulse has tumbled into negative territory (but that’s a different topic).
Going back to Goldman, Hatzius adds that “we find that the sensitivity of financial conditions to monetary policy shocks has been quite high recently, at least when we identify these shocks using bond market moves around FOMC meetings. This suggests that the easing of financial conditions is due to other factors, most obviously the improved global environment, not reduced traction of monetary policy.”
What form will this monetary tightening “shock” take place? “
Our best (though uncertain) answer is that the committee will need to deliver 50-75bp more hikes per year than priced in the forwards to stabilize the economy at full employment. This is roughly consistent with our current funds rate call that we will see an average of 3-4 hikes per year through the end of 2019, compared with market pricing of just over 1 hike.”
Of course, if Goldman is wrong and the Fed has no intention of sending risk assets into a tailspin with a monetary policy “shock”, then there is no saying just how much further the combined effort of China’s gargantuan, if cooling, credit expansion, coupled with the “dovishly” hiking Fed can take stocks. However, by now it is becoming clear to even the most resentful permabulls – and even Goldman – that the longer the Fed delays the day of reckoning out of pure fear of the unknown, the greater the chaos and loss in asset values when the Fed no longer has the luxury of picking when to pull the switch.
