The Federal Reserve has spent the past four years trying to cool price increases through higher interest rates. The federal funds rate is still well above its pre-pandemic average, mortgage rates remain elevated, and borrowing costs for households and businesses are considerably higher than they were in the era of ultra-low interest rates.
But is monetary policy slowing the economy? Fed Chair Kevin Warsh argued at the Federal Reserve’s Jackson Hole conference that despite higher rates, it is difficult to describe credit conditions as restrictive. An examination of financial conditions suggests he may have a point.
What ultimately matters is how easily households and businesses can obtain financing. In some economies, that question is determined largely by banks. In Europe, for example, banks account for about 80% of the credit received by businesses. Capital in the United States is more often raised in the bond and stock markets, where investors and borrowers meet more directly, bypassing the banking system altogether. Market-based sources account for a little over 50% of the financing used by U.S. companies.
As a result, financial conditions involve much more than interest rates and bank lending standards. To capture the overall availability and cost of credit across the economy, measures of financial conditions typically include indicators such as equity prices, credit spreads, and market volatility. Strong asset prices, narrow credit spreads and low volatility generally signal that financing remains readily available.
Financial conditions indexes can be complex in their construction but are simple in their interpretation. If readings are above a certain level, conditions are tight. Below that level, they are easy. At present, measures of financial conditions compiled by the Federal Reserve and private sector providers remain firmly in easing territory.
Part of the explanation lies in the resilience of risk appetite. Healthy corporate balance sheets have reduced concern about defaults, compressing corporate bond spreads to near historical lows and making it cheaper for companies to raise financing. Equity markets have continued to climb as earnings have exceeded expectations, creating opportunities to raise capital from this source.
See more: What Is a Market Bubble?
Another reason financial conditions appear easier is the growing importance of alternative sources of finance. Private credit and private equity have increasingly stepped in to provide capital beyond the reach of banks and public markets, creating additional channels of funding that are not always fully captured by traditional measures of financial conditions. The artificial intelligence (AI) boom illustrates this trend: leading AI firms, data center developers and semiconductor providers are all heavily reliant on private capital.
The critical question is whether today's financial backdrop is restrictive enough to keep inflation contained. While the Fed has been attempting to remove accommodation with one hand, financial markets have been adding it back with the other. Policy rates may still be high, but the broader financial environment does not look especially restrictive.
If inflation proves stubborn in the year ahead, the reason may not be that the Fed failed to raise rates enough. It may be that easy financial conditions have offset part of their intended effect, leaving policymakers with more work to do.
Vaibhav Tandon is the Chief International Economist within the Global Risk Management division of Northern Trust.
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