- Financial conditions are hard to measure
- …and even harder to make sense of
“Financial conditions”: a term that sounds both technical and concrete when bandied around in monetary policy statements and analysts’ reports. The reality is quite different.
At its most simple, the phrase describes how easy it is for people and businesses to access finance. It will come as no surprise to hear that financial conditions typically tighten as interest rates increase. This means that, in theory, these conditions can serve as an early indicator of how higher rates are feeding through to the economy.
If only things were so simple. The first problem is that economists do not agree on what ‘financial conditions’ really constitute – let alone how they should be measured. Even the Bank of England (BoE) has described it as “a somewhat imprecise economic concept, and not something we can measure directly or easily summarise using any single indicator”.
Economists construct a number of financial conditions indices (FCIs) to try to solve the problem, which look at a variety of different variables to create a summary measure. The Goldman Sachs FCI uses riskless interest rates, the exchange rate, equity valuations and credit spreads – all weighted to correspond to the impact of each variable on gross domestic product (GDP). The BoE’s monetary and financial conditions index looks at slightly different values, including mortgage spreads and measures of the weighted average cost of capital. This means that there is no one definitive measure. According to the BoE, “FCIs differ considerably depending on the variables they include and the weights used, and are often looking to answer different questions”.
Even more confusingly, financial conditions aren’t tightening as expected today. In a June note, TS Lombard economists said that “central banks promised ‘pain’ but stock markets are higher and the global economy hasn’t buckled (yet…)”. One interpretation is that interest rates are still low in inflation-adjusted terms, meaning financial conditions are correspondingly loose. Yet the economists note that interest rates and debt-servicing costs are at their highest levels in decades, leaving “no doubt that central banks’ policies are genuinely restrictive”.
This could be down to policy lags masking the impact of higher rates, particularly in sectors less exposed to borrowing costs. After the last rate-setting meeting, Fed Chair Jay Powell spoke at length about the uncertainties surrounding financial conditions, and noted the long-running debate about the time lags involved. He said that monetary policy was already “restrictive”, and added that “we can afford to be a little patient as well as resolute as we let this unfold”.
Yet interest rates are not the only factor that can influence conditions: changes in risk appetite, expected future returns and the creditworthiness of borrowers can also have an impact. This means that central bank communications can have an impact, too.
Jamie Nieven, a fund manager at Candriam, is among those who think that the BoE will probably take a cautious approach to further interest rate hikes – not that rate-setters will let on. After last month’s meeting, Nieven said that “it would have been dangerous to communicate this alone given its potential impact on financial conditions”. He added that the BoE “prefers to imply” higher rates for longer, as a result. Yet these might not materialise. According to Nieven, “the current restrictive levels will cause a larger growth impact, eventually resulting in lower policy rates than currently implied by market expectations”.
Yael Selfin, chief economist at KPMG, agrees that rising interest rates will drag on growth further. She said last month that “we are yet to see the full impact of significantly higher borrowing costs on economic activity and inflation”. The impact of quantitative tightening adds another layer of uncertainty. Selfin added that “the ongoing process of selling the Bank’s holdings of government bonds back to the market could further tighten financial conditions by putting upward pressure on yields”.
All of which shows that these conditions are, in truth, an imprecise gauge of economic activity.
