The key to Fed policymaking

From: POLITICO's Morning Money - Friday Jul 15,2022 12:01 pm

Jul 15, 2022

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Financial conditions have tightened a lot — You might have heard this in the context of something the Federal Reserve wants to see. Tighter financial conditions mean borrowing money is harder and asset prices are lower. And even though you hear a lot about the federal funds rate, what the Fed is really trying to influence is financial conditions. But figuring out whether they’re in the right place to bring down inflation is difficult, to say the least.

In simple terms, indices that measure financial conditions look at things like stock prices, the gap between interest rates paid by borrowers across the spectrum of creditworthiness, the strength of the dollar, volatility, etc.

Financial conditions feed into real economic activity (business creation, mergers, homebuying, employment, spending, etc.) which affects inflation. But how one step will flow through to the next is hard to estimate with any certainty. Understanding how it all works matters because, while most of us closely follow every Fed decision on interest rates, central bank officials themselves are looking at a dashboard of factors to gauge the impact of their policy moves on markets and economic activity. Those conditions, in turn, influence the central bank’s next moves.

“If you think of financial conditions instead of a spot interest rate perspective, they incorporate not just where the Fed’s target rate is now, but where the Fed expects it to be down the road,” said Julia Coronado, president of MacroPolicy Perspectives. Indeed, investors price in their expectations of future Fed moves. “There’s a lot of questions about, are the lags from financial conditions to the economy shorter than the lags from interest rates to the economy?”

For example, financial conditions might give you a different answer to this question: Is the Fed still boosting the economy with its interest rate stance, or is it actually starting to tap on the brakes? Rates, after all, are still low by historical standards. But financial conditions suggest the Fed is helping the economy less than the pure level of rates would suggest.

Financial conditions are also the main consideration in how quickly the Fed should ramp up rates each meeting; after all, it doesn’t want to break anything in markets.

Lou Crandall, chief economist at Wrightson ICAP , said the rapid pace of change is more important than the level of rates to markets, “which is why I’m perfectly willing to call the Fed’s current stance effectively restrictive.” Still, he said, financial conditions are not something the Fed can easily target, particularly since the relevant components of financial conditions might shift as finance evolves.

“It’s more a conceptual issue than something we can quantify,” he said. “I’m always skeptical of economists’ desire to quantify the unquantifiable.”

But if you wanted to quantify it? A Bloomberg measure of financial conditions shows the U.S. about 0.5 below neutral, which is consistent with slow growth (but not quite a recession). The past couple of years, that index was around 1 above neutral, which Coronado called “extremely stimulative.” By comparison, at the onset of the pandemic, when financial markets began breaking down, it was at -6. The 2008 financial crisis? -12.

IT’S FRIDAY! — Kate Davidson will be back on Monday. Send tips to kdavidson@politico.com or @KateDavidson, or aweaver@politico.com or @aubreeeweaver. And you can always reach me at vguida@politico.com.

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Driving the Day

JPMORGAN SEES TURMOIL BREWING BUT FEW SIGNS OF RECESSION — WSJ’s David Benoit and Charley Grant: “Second-quarter profit at JPMorgan Chase & Co. fell 28% from a year earlier even as the nation’s largest bank said it is seeing few signs that a recession is imminent, underscoring the uncertainty looming over markets and the economy.

“The New York company said customers continued spending despite rising inflation, businesses continued borrowing and loan losses remained practically nonexistent. But executives said there remains more uncertainty than normal, dragging down big corporate activity such as mergers and acquisitions and leading the bank to set aside more funds for potential future loan losses.”

DEMS’ TAX CUT DREAMS MEET ELECTION-YEAR REALITY — Our Burgess Everett and Sarah Ferris: “Jon Tester isn’t up for reelection this fall, nor is he threatening to oppose a party-line Democratic bill that might increase taxes. He still has a warning for his colleagues. ‘I don’t think raising taxes is a winner anywhere, OK?’ Tester said in an interview.

“If Democrats can pass a bill that cuts the deficit and drug costs, the Montanan added, ‘there’s some positive things you can talk about. But the bottom line is that no, taxes are never a winner. We need to be very careful.’”

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POWELL, CLARIDA CLEARED BY FED WATCHDOG — From your MM host: The Federal Reserve’s inspector general on Thursday cleared former Vice Chair Richard Clarida and Fed Chair Jerome Powell of wrongdoing in an ethics scandal centered on trading activity by top central bank officials. Clarida, who stepped down in January, came under investigation after trades he made in February 2020 drew scrutiny as part of the broader scandal that also led to the resignation of two other top Fed policymakers.

The IG said Clarida discovered during the watchdog’s investigation that he had failed to fully disclose financial transactions in February 2020. That omitted trading activity came to light after being reported to the Office of Government Ethics late last year, and Clarida resigned his post shortly thereafter. The IG found that the exclusion of that additional trade was “inadvertent.”

The investigation also found that a financial adviser for Powell’s family trust improperly made trades during the blackout period around a Fed policymaking meeting in December 2019. The inspector general said there was no evidence that either Powell or his wife “had contemporaneous knowledge that the five transactions were executed during the blackout period.” The trades were designed to make funds available for annual charitable donations, according to the watchdog.

MM sidebar: The report was very bare bones and won’t satisfy any skeptics. Hopefully we’ll get more info; the IG is still in the middle of its investigation of former Dallas Fed President Robert Kaplan and former Boston Fed President Eric Rosengren, both of whom also departed the central bank after problematic trading activity came to light. The watchdog suggested that future reports could shed more light on why Clarida’s trades did not break any rules, a matter that is almost entirely skirted in the initial report.

BETTER MARKETS REACTS — “The IG inexplicably took a very, very narrow view of the Fed’s policies applicable to the trading it did review and then limited its review to the ‘policies as investigated by our office.’” Read the group’s full response here.

FED OFFICIAL: FULL POINT HIKE POSSIBLE, BUT NOT YET — NYT’s Jeanna Smialek: “Christopher Waller, a Federal Reserve governor, said he supported increasing the central bank’s policy interest rate in July by the same amount as in June, though he suggested that an even larger move could be warranted if economic data continued to come in hot.

“The Fed raised interest rates by 0.75 percentage points last month, its largest increase since 1994, in an effort to quickly slow down borrowing and spending and cool off an economy that is experiencing the fastest inflation in four decades. Investors had expected a similar move at the central bank’s July 26-27 meeting, but then a fresh inflation report this week came in unexpectedly high.”

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Fly Around

BOFA FINED $225M OVER BOTCHED JOBLESS BENEFIT DISTRIBUTION — Our Katy O’Donnell: “Federal regulators on Thursday fined Bank of America $225 million for allegedly wrongly freezing accounts linked to unemployment benefits during the pandemic because of a faulty fraud-detection process.

“At the time, the bank had contracts with various state agencies to facilitate unemployment insurance payments to recipients electronically through prepaid debit cards and accounts. In response to surging fraud in the fall of 2020, Bank of America implemented an automated filter to flag potential fraud on those accounts.”

WALL STREET TEXTING STICKS BANKS WITH $1B BILL — Bloomberg’s Sridhar Natarajan, Katherine Doherty, Hannah Levitt, and Matt Robinson: “Regulators are poised to extract about $1 billion in fines from the five biggest US investment banks for failing to monitor employees using unauthorized messaging apps.

“Morgan Stanley disclosed on Thursday that it expects to pay a $200 million fine, the same amount JPMorgan Chase & Co. paid as authorities use that settlement as a yardstick for the industry. Citigroup Inc., Goldman Sachs Group Inc. and Bank of America Corp. also have had advanced discussions with the regulators to each pay a similar figure, according to people with knowledge of the talks who asked not to be identified because the matter isn’t public.”

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COINBASE MAY DROP FROM RANKS OF TOP CRYPTO EXCHANGES — Bloomberg’s Olga Kharif: “Coinbase Global Inc. is falling out of the coveted list of the world’s top 10 digital-asset exchanges by volume as the markets battle crypto winter. The latest data for this month so far shows the firm is now the 14th largest exchange, down from the fourth-biggest in late 2021, according to Mizuho Securities USA LLC.

“The main exchange for digital tokens in the US only had a 2.9% average market share among the top 30 exchanges globally so far this month, Mizuho said. That’s down from 3.6% average in the second quarter of this year and 5.3% in the first quarter, the report said.”

THE LATEST ON ELON MUSK — CNBC’s Laura Feiner: “The Securities and Exchange Commission asked billionaire Elon Musk for more information on a tweet related to his $44 billion acquisition of Twitter that he’s recently tried to call off, a new regulatory filing Thursday shows.

“The disclosure sheds light on how Musk represented his commitment to the deal to the SEC, even as he probed Twitter for information on spam accounts on the platform. It also shows how the deal could again bring Musk into the crosshairs of the agency.”

Say hello: Boston Fed President Susan Collins debuted her first public remarks since taking over the regional bank in a new video, where she calls inflation “too high.”

DOJ POISED TO REBUFF GOOGLE — Bloomberg’s Leah Nylen: “The US Justice Department is likely to reject concessions offered by Alphabet Inc., clearing the way for an antitrust lawsuit over Google’s dominance of the online advertising market, according to people familiar with the matter.

“While Google has made at least one settlement offer to the Justice Department’s antitrust division to address its concerns, the agency is poised to file a lawsuit in the coming weeks, two people said, speaking anonymously to discuss a confidential probe.”

A message from Sallie Mae®:

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