Introduction

If the Federal Reserve’s main policy goal these days is to tighten financial conditions, then it should be pretty close to achieving its goals, according to an analysis by Evercore ISI. While the Fed is using its monetary levers directly to try to bring down inflation, officials measure their progress through the impact on a host of other metrics, including bond yields, employment data, stock market and real estate prices, and the U.S. dollar.

The Fed has recently introduced its own measure called the Financial Conditions Impulse on Growth (FCI-G). Evercore expects this index to show that conditions have tightened substantially, as evidenced by rising Treasury yields, due to the central bank’s ongoing rate-hiking campaign.

Tightening Financial Conditions

Krishna Guha, head of global policy and central bank strategy at Evercore ISI, stated that the recent surge in bond yields has contributed to the fall in stock prices, pushed up mortgage and corporate borrowing rates, and generated upward pressures on the dollar. Guha believes that the Fed will have to consider the tightening in financial conditions when making decisions about interest rate hikes in the upcoming months, including the possibility of a hike in September.

Evercore estimates that the shift in conditions will have a significant negative impact on GDP growth over the next few years. According to their projections, there could be a 0.76 percentage point drag on growth in the next year, followed by a 0.15 percentage point hit in 2025 and 0.1 point the following year. These projections could convince Fed officials that they have done enough to slow the economy and bring down inflation, potentially eliminating the need for further interest rate hikes.

Market Expectations

Market pricing aligns with the belief that the Fed will pause its rate-hiking cycle after raising rates 11 times since March 2022. Traders currently assign about a 37% chance of one more rate hike in November, followed by a series of cuts through 2024, according to CME Group data.

Challenges and Uncertainties

However, there are factors that challenge this narrative. Economic data has been stronger than expected, as indicated by the Citi Economic Surprise Index reaching its highest level in more than two years. Additionally, the Cleveland Fed’s inflation forecasting model predicts a 0.8% rise in the consumer price index for August, which would exceed the 2% goal set by the central bank. This suggests a potential increase in inflation that could complicate the Fed’s decision-making process.

Despite these challenges, the Evercore strategists believe that the tightening of financial conditions will ultimately make it more difficult for the Fed to justify another rate hike. They argue that it will be viewed within the Fed as creating a safe context to move gradually and carefully on hold for the remainder of the year.