Analysis: There’s more to normalisation than short rates, financial conditions matter
Market focus on central banks is currently on the pace and extent of rate hikes in this cycle. Importantly though when talking about the stance of monetary policy, it is not just about the cash rate, but how broader financial conditions are influencing the economic outlook. Financial conditions should be looked at closely in this cycle given the array of unconventional tools used in the pandemic that are set to be unwound.
In this Weekly, we calculate financial conditions indexes for Australia, the US and Europe, and decompose these indexes into drivers. The indexes we calculate broadly shadow the widely used Goldman Sachs Financial Conditions Index for the US. The recent sell-off in global equities and higher longer-term yields have broadly raised financial conditions back towards average levels, which were prevalent in 2014/2015.
More specifically, we find that around two-fifths of the tightening in US financial conditions since the end of last year is attributable to the decline in the price to earnings ratio alongside the selloff in US equities (note the S&P500 is down 17.5% from its peak). Another two-fifths comes from the selloff in longer-term rates and a widening in corporate spreads.
With financial conditions around average, it is clear financial conditions have tightened by more than what’s implied the shift in policy rates alone. Part of the lift in financial conditions is markets anticipating how high rates may need to go in this cycle, and the consequent lift in longer-term yields. Another important factor is unwinding unconventional monetary policy including through quantitative tightening. How should we interpret this?
Financial conditions are not a perfect summary of the stance of monetary policy, but do contain useful information about how broader financial conditions could influence the outlook. Fed Chair Powell has cited financial conditions as a barometer for policy, “we will go until we feel we’re at a place where we can say financial conditions are in an appropriate place, we see inflation coming down.”. and that “… the idea, again, is to have financial conditions tighten to the point where growth will moderate.”
For monetary policy, the tightening in financial conditions may mean central banks are not as far behind the curve as simple metrics such as the short-term policy rate may indicate. Inflation and the trajectory of inflation of course will be the ultimate arbiter in assessing how far rates need to go in this cycle, and whether rates need to move into restrictive territory. The broader set of factors captured by financial conditions indexes will also be important in assessing the likely impact of tightening on the economic outlook.
For Australia, the importance of financial conditions for the RBA is less clear. The RBA has tended to communicate its policy stance via its outlook for the cash rate, rather than explicitly referencing financial conditions – the QE experience the exception. Nevertheless, with the balance sheet set to shrink and global growth risks rising as other central banks hike rates, it will be important to monitor financial conditions going forward.
Chart 1: Australian financial conditions now at 2014 levels