When the US Federal Reserve suggested four years ago that it might start tightening monetary policy, the mere idea sent the markets into a tailspin - or a “taper tantrum” as investors feared the consequences of higher borrowing costs.
These days, however, something remarkable is under way. During the past 18 months the Fed has raised rates by 25 basis points on three occasions and may implement a fourth rise when the Fed governors meet next week. But this time, there has been no tantrum; quite the opposite. Never mind the fact that the S&P 500 share index is hitting records, or that 10-year US bond yields have fallen to 2.14 per cent this week.
What is even more striking is the behaviour of measures known as the “financial conditions” indices. These are barometers compiled by groups such as Goldman Sachs or the St Louis Fed from data on long and short bond yields, credit spreads, currency movements and equity prices that indicate how hard it is to borrow funds.
These indices have tumbled in the past year, suggesting that financial conditions have become much looser. The St Louis Fed index, for example, is at its lowest point since 2014; the Goldman index is at a two-year low, suggesting that finance has become cheaper and easier to find in the markets, never mind those rising Fed rates.
This leaves the Fed looking like the pilot of an airliner with a wonky rudder. Fed officials may have yanked on the controls, but the aircraft has moved in the opposite direction of what was planned. In other words, the transmission mechanism between policy, the economy and markets is at least temporarily broken.
This is not the first time that this has occurred. During the aftermath of the 2008 financial crisis the mechanism was broken in the opposite way: the Fed tried to loosen policy, but financial conditions tightened amid a panic. And before the crisis, a pattern developed that looked similar to today: between 2004 and 2006 the Fed raised rates 17 times, yet the financial conditions index loosened sharply, amid a credit boom.
While the pattern might not be new, it raises a vexing question now: should Fed officials respond to the loosening of conditions by pulling even harder on the lever and raising rates faster? Or do they simply ignore it?
Some Fed officials seem inclined to ignore it. Markets are fickle, and the financial conditions surveys are somewhat subjective, since each institution tends to calculate the indices in a slightly different way.
In any case, the Fed is not supposed to set its policy just by watching markets, since that risks creating feedback loops where the markets and Fed end up just responding to each others signals. Janet Yellen, the Fed governor, insists that policy is “data dependent” - and that the numbers it emphasises are of the hard, “real economy” type , such as figures on unemployment and inflation.
As it happens, these “hard” economic signals have recently been somewhat weak. Inflation is now 1.5 per cent, below the Fed target of 2 per cent. This leaves some Fed officials arguing against rapid rate rises, never mind what those financial conditions indices say.
Other observers, such as Bill Dudley of the New York Fed, seem more concerned. Earlier this year he gave a speech calling for economists to pay far more attention to signals such as the Goldman Sachs index (which he helped develop when he worked there). Unsurprisingly, he now seems to be pushing for a rate rise.
I think that Mr Dudley is right. His point about the interplay of markets and the wider economy should be made far more strongly. After all, the fact that Fed economists did not pay much attention to the financial conditions index before 2007 is why the credit bubble got so badly out of control.
If they ignore the pattern now, they risk repeating that mistake. There is a practical point too: if the Fed raises rates now, that will strengthen its hand in the future if it faces any showdown with the US administration about the direction of the economy and its wider fiscal stance; if it delays it may be much harder to act later, from a political point of view, particularly if debt levels start to rise.
But no pilot ever likes to admit that the rudder of their aircraft might be flawed or that they do not quite understand why it is not working; that would undermine the confidence of the passengers, not to mention the pilot’s own sense of self worth. So it will be interesting to see what the Fed does next week; and how much (if at all) Mrs Yellen mentions those financial conditions indices if a fourth rate rise does occur.
