Fed paper: Financial conditions tightest since crisis over a decade ago

1:02 pm Friday, June 30th, 2023

By Michael S. Derby

(Reuters) – The financial sector is taking the biggest bite out of U.S. economic activity since the nation was mired in the financial crisis over a decade and half ago, a new paper from the Federal Reserve, released on Friday, said.

The finding came as part of researchers’ work to construct a new financial conditions index to measure how a wide array of financial factors can affect overall activity.

In the paper, the economists wrote that based on the most recent findings of their work, “financial conditions are estimated to be a drag on [gross domestic product] growth of roughly 3/4 percentage point over the next year.” They added their measure, called Financial Conditions Impulse on Growth, or FCI-G, is at its “tightest level” since the global financial crisis that kicked off in 2008 and brought the global economy to the brink of collapse.

The authors wrote that since the close of 2021 tighter financial conditions have been driven by lower stock prices, the broad jump in interest rates, including those affecting home borrowing, and a stronger dollar. Over the second half of 2022, the paper said “the largest headwinds to future growth” are being generated by short and long-term interest rates and the dollar, “whereas past appreciation in house prices and equity prices recorded over the pandemic continues to be a tailwind to [gross domestic product] growth.”

The new index arrives in an increasingly well-populated space, amid both private and public offerings. The paper’s authors note that their offering “is broadly consistent” with how the Fed’s in house model of the economy “generally relates key financial variables to economic activity.” They also said that compared to other financial condition indexes, or FCIs, their offering better tracks the past impact of changes in financial variables.

The paper also notes that its index is not fully on the same page as other offerings right now. “In recent months, a wedge has appeared between the FCI-G and other FCIs, reflecting the lags through which the rapid and sustained tightening of financial conditions recorded in 2022 acts as a headwind to future GDP growth,” the authors wrote.

Financial conditions are a key focus of the Fed given that monetary policy changes work through the economy by affecting them. The central bank has aggressively raised rates over the last year in a bid to cool high levels of inflation and has sought to engineer tighter financial conditions in order to slow activity.

The Fed paused on raising rates earlier in June in large part to see how the broader tightening in financial conditions is weighing on the economy amid evidence inflation pressures are gradually waning.

(Reporting by Michael S. Derby; Editing by Andrea Ricci)