Saturday, December 9, 2017

Financial conditions - No signal of tightening. Trend says stay the course with risky assets



The Fed has become more focused on financial market conditions since the Financial Crisis. There is less interest in the classic goal of managing full employment since by many measures we may beyond the natural rate of full employment, and there is admitted confusion on how to control inflation.

However, macro prudential policies, systemic risk, and financial fragility have been the places of greater policy emphasis and monitoring over last decade. Hence, any focus on Fed policy should give weight to current financial conditions and stress measures. If the Fed is raising rates but financial conditions are not tightening, then further rate increases are not likely to harm full employment. Given the confusion on policy inflation links, financial condition indices may be a more effective policy monitor for both the Fed and investors.

Three widely watched financial condition and stress indices have been developed by the Fed banks of St Louis, Kansas City, and Chicago. They are all showing the same trend. Financial conditions are easing not tightening. Hence, this should be a green light for further rate increases and a clear sign that there should be any worry that Fed policy will negatively impact risky assets. If the trends in financial conditions are positive, continue to follow the trends in financial assets.

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