Easing financial conditions pose a problem for the Fed

Despite long-term Treasury yields rising sharply this week to their highest level in four years, broader measures suggest that overall financial conditions have actually continued to loosen. Corporate bond spreads have fallen to levels not seen since 2007, banks are continuing to relax lending standards and the stock market remains close to a record high. Most notably, after the 7% depreciation in 2017, the dollar has already fallen by a further 3% in trade-weighted terms so far this year. Incoming Fed Chair Jerome Powell, who will be sworn in on Monday, is widely expected to continue Janet Yellen’s gradual approach to raising interest rates. If financial conditions continue to loosen even as the Fed tightens policy, however, Powell’s first year as Chair could easily see the FOMC take a more hawkish turn. Along with signs that wage and price inflation is rebounding, this is another reason to expect the Fed to end up hiking interest rates this year by more than most currently anticipate.