Where I live, in the Northeast, early spring can be unsettling. Warm, sunny hours can be followed by chilling rains, relentless wind, snow, or worse.
Like spring’s unpredictable weather, financial conditions can be volatile, as we witnessed last month.
On March 22, the Federal Reserve said it would raise interest rates for the ninth straight time. Speaking to reporters after the decision, Fed Chair Jerome Powell pointed out that financial conditions had tightened recently, which “would work in the same direction as rate tightening”.
To understand what that means for us here on Main Street, here’s a look at the country’s current financial conditions, and how they play into the Fed’s decision to raise interest rates.
What are financial conditions?
Financial conditions are the links between Main Street and Wall Street. While definitions vary, financial conditions for the most part are measured by four main components – Treasury interest rates, credit spreads, the exchange value of the U.S. dollar, and equity prices.
Treasury rates are the backbone of lending in the United States. Treasurys can be very short term, such three-month bills, or very long term – think 30-year bonds. Most consumer and business lending is anchored to interest rates, or yields, paid by Treasurys.
A classic example are mortgages, where rates tend to move in sync with yields on 10-year Treasury bonds. The cost of a home loan has soared from a record low of 2.65 percent in January 2021 to 6.32 percent on March 30, as the yield on 10-year Treasuries trended upward.
Credit spreads capture the relationship between bonds and borrowers. Spreads get wider – the cost of borrowing goes up – the less creditworthy a borrower is. Think of Treasury bonds as the gold standard of credit quality, backed by the full faith and credit of the U.S. government. Because they’re so safe, they tend to pay very low interest rates.
All other bond issuers – businesses, local governments, school districts – are higher risk, and thus issue notes that pay a higher rate of return, or yield, to investors who buy them.
This spread between different bonds of different yields varies depending on economic conditions.
If you’ve traveled internationally, you’re familiar with exchange rates. The value of the U.S. dollar compared to other currencies affects the cost of imported goods that are sold in the United States, and the cost of exports that U.S. businesses sell abroad.
Finally, the rise and fall of stock prices, including the baskets of shares that many consumers own in the form of exchange-traded funds or mutual funds, are a key contributor to household wealth and business financing that can affect spending and investment.
Why are financial conditions important?
Just as weather conditions play a role in the overall climate, financial conditions affect the economic climate. They can determine both the cost of borrowing and the availability of funds.
Economists typically describe financial conditions on a spectrum between loose and tight. Loose conditions mean financing is cheap and readily available. If the market is tight, funds are more expensive and harder to get.
If financial conditions are loose, it’s relatively easy and cheap for consumers and businesses to borrow. That increased borrowing can lead to increased spending and greater demand for goods and services, which can power economic growth (good) and possibly drive up inflation (bad).
If financial conditions are tight, investment and spending could be restricted, slowing demand and taming inflation (good). But persistent financial tightness could slow economic growth too much, resulting in recession (bad).
What does this have to do with the Fed?
The Federal Reserve is the financial meteorologist for Main Street. Fed policymakers monitor financial conditions to determine how higher or lower interest rates will help or hurt the economy.
Financial conditions, however, are just one aspect of the economic climate that the Fed monitors. Data on labor market activity, consumer sentiment and spending, business investment, home sales, inflation, and a whole host of other economic metrics feed into monetary policy.
For the past year, the Fed has been focused on reducing inflation to its 2 percent target. By raising interest rates – and thus the cost of borrowing – Powell and his team hope to chill inflation.
Last week the Fed’s preferred inflation gauge dipped modestly to 4.6 percent for the 12 months ending in February, down from 4.7 percent over the same period ending in January. Inflation is still more than double the Fed’s 2 percent target.
Loose financial conditions can slow Fed progress against inflation. Tight conditions can speed it up. Over the past few weeks, financial conditions have tightened due to uncertainties in the banking sector.
As we head into the week, new jobs data will take center stage. The Bureau of Labor Statistics releases data on job openings Tuesday. ADP publishes its March National Employment Report Wednesday. Initial jobless claims, a measure of layoffs, take their turn Thursday after edging up the week before. Friday brings the big finale, the monthly non-farm payrolls report from the BLS. With each of these data releases, we’ll be watching whether March cooled or warmed hiring. Like early spring weather, financial conditions are temperamental and can change unexpectedly. The Fed, as Main Street’s monetary meteorologist, must be prepared for rain or shine.