Back in May, we first reported that Goldman became the first bank to dare to ask if the Fed, and Janet Yellen, have lost control of the market, if in slightly more polite terms. This is how Jan Hatzius phrased it: “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.” Several months later, after the third rate hike, Goldman found that once again, paradoxically, financial conditions eased further, in direct opposition of what Fed rate hikes are supposed to do!
Fast forward to this weekend, when we reported that that lovely word which describes the new normal so well – “paradox” – made a repeat appearance, this time in the last quarterly report by the Bank of International Settlement, which for the nth time issued an alert on the sate of the stock market, an alert which will be summarily ignored by everyone until after the crash, and reminded everyone what happened the last time financial conditions eased instead of tightening when the Fed hiked rates (spoiler alert: biggest crash in modern history). This is what the BIS’ chief economist Claudio Borio said (among other things)”
Hence a paradox. Even as the Fed has proceeded with its tightening, overall financial conditions have eased. For instance, a standard indicator of such conditions, which combines information from various asset classes, points to an overall easing regardless of the precise date at which the tightening is assumed to have started. Indeed, that indicator touched a 24-year low. If financial conditions are the main transmission channel for tighter policy, has policy in effect been tightened at all? (We can see from the BIS chart below how, unlike the last 12-month period, the Chicago Fed Financial Conditions Index did actually tighten in the May 2004-May 2005 period, and especially in the January 1994-January 1995 period.)
“In fact, this paradoxical outcome is not entirely new… it is reminiscent of the Fed policy tightening in the 2000s – the phase that spawned the now famous “Greenspan conundrum”. Then, overall financial conditions hardly budged, and in some respects eased, as the Federal Reserve progressively raised rates. The experience contrasted sharply with previous tightenings, not least the one in 1994. At that time, long-term rates …read more