Instead, the Fed typically focuses on financial conditions. There are several measures of financial conditions, or financial stress, tracked by the Fed. Figure 4 shows the Cleveland Fed’s measure of financial stress, which is a coincident indicator of systemic stress where a high value indicates high systemic banking stress. It aggregates stress levels in equity, credit, foreign exchange (currency), interbank lending, real estate, and the securitization markets. Over time, a rising level of stress indicates tightening financial conditions.
While financial stress has ebbed in the past few weeks, the stress level remains elevated from where it started the year, and, perhaps more importantly, where it was just after the Fed raised rates in mid-December 2015. Said another way, the financial market itself has done the Fed’s job of “tightening policy” and slowing the economy over the past three months or so. However, if financial stresses continue to fade, as they have over the past few weeks, we would expect the Fed to continue to tighten policy the old fashioned way—via higher interest rates—potentially as soon as the April 26–27, 2016 FOMC meeting.
John Canally is chief economic strategist for LPL Financial.