Can one small hike cause a giant tightening?
Can we be sure the Fed has only tightened 25 basis points?
In our view, the 25bp of Fed hikes reveals little about how much the Fed has truly tightened. The
"liftoff" from extraordinary, unconventional monetary easing to the start of tightening was an enormous
leap. Several measures suggest the Fed's hawkish shift was even greater than in either the 1994 or 2004
rate hike cycles.
If the policy rate doesn't reflect policy tightening, then what does?
We consider a range of market metrics typically included in financial conditions indexes. From credit
spreads to the dollar, it appears the Fed has gotten far more "bang for its buck" when it comes to
tightening.
We attempt to capture tightening by converting market metrics into rate hikes
We aim to create a common language for interpreting tightening of "financial conditions" by translating
changes in financial market variables into fed funds rate equivalents. We do this by gauging how shocks
feed into future economic activity, and standardize the measures as if they had been fed fund rate
increases.
Financial conditions delivered more than 250bp of "hikes" through January…
We find that the most tightening was transmitted through wider credit spreads, the stronger dollar, and
tighter credit standards, while falling 10-year Treasury yields were equivalent to rate cuts. We estimate
that the combined tightening from September 2014 to January 2016 was equivalent to 273bp of
tightening.
Market rebound since early-2016 did not offset past stress with "cuts"
The tightening of financial conditions motivated the Fed's dovish turn in March, and conditions have
eased since: credit spreads narrowed, equities rose, the dollar weakened, and Treasury yields fell further.
We estimate easing since January provided a combined 134bp "cut" offset, leaving a high degree of net
tightening (~139bp).
Why does this matter? Greater sensitivity and less space for hikes
Fed tightening may not be properly understood. The Fed likely has a shorter distance to go with rate
hikes this cycle, and may have already delivered a significant chunk of tightening indirectly – via financial
conditions. Future hikes may have less of an impact than the first; nonetheless, if hikes continue to have
substantial market consequences, the risk the Fed runs is unintended cooling of the economy with
fewer-than-intended hikes. This is obviously a risk for equities and a driver for flatter curves in fixed