Investors have greeted the Federal Reserve’s recent string of interest rate increases with some of the most docile market conditions in years, a sign that they could be in for a shock if the central bank decides to ramp up the pace of rate rises next year.
The Goldman Sachs Financial Conditions Index, a widely-watched measure of how easily money and credit flow through the economy via financial markets, was this month at its lowest level since 2014. Financial conditions are now looser than they were before the Fed began lifting rates in 2015.
Typically, the prospect of Fed rate increases tightens financial conditions by pushing up borrowing costs for companies and governments, lifting the value of the U.S. dollar against its peers, and restraining a rise in the stock market.
But that hasn’t happened this time around. Two years into the Fed’s rate-rise cycle, stocks have been on a near-uninterrupted climb and longer-term Treasury yields have barely budged and lingered near the technically-important level of 2.4% for much of the past few months. The WSJ Dollar Index, a measure of the U.S. currency against 16 peers, is down 3% from its December 2015 level.
Markets have rewarded investors who continued to take risks in large part because the Fed has lifted rates more slowly than in past cycles. After this week’s expected increase, the Fed will have lifted rates just five times in two years. By contrast, the Fed’s last tightening cycle stretched over a total of two years and included 17 increases.
The Fed has been slow to move this time because the economy and financial markets have shown few signs of overheating. Though there are concerns in some corners that the prices of stocks and other assets have climbed too far, the economy has been muddling along and inflation remains below the Fed’s annual target of a 2% rise.
But that raises concerns about whether financial conditions will tighten abruptly if the Fed opts to lift rates faster in the new year. Jerome Powell is expected to take the helm of the central bank in 2018, and could shift course, particularly with a new batch of policy makers expected to favor faster rate increases. If inflation begins to accelerate next year, the pace of rate increase could also pick up, economists say.
Investors and central bankers had a long face-off with very divergent expectations about how quickly growth and inflation would pick up, and how much policy makers would need to do to address improving conditions. After lowering their forecasts throughout 2016, Fed officials stuck to their guns in 2017, and the market has moved toward the Fed’s more recent, and less aggressive projections.
Source: Dow Jones