Economists at Deutsche Bank use a financial conditions framework to assess how many more turns of the monetary wrench the Fed would need to return price pressures to their 2% target.
“It would take a sharp and aggressive tightening of financial conditions from here to push inflation much closer to price stability,” says its chief US economist, Matthew Luzzetti.
Deutsche Bank says that would be more than 0.7 on the adjusted Chicago Fed National Financial Conditions Index, which right now is near zero.
Historically, 0.7 has corresponded with a recession probability over the next 12 months of 50%, Deutsche Bank estimates, and they forecast the Fed will have to push on into restrictive policy.
“If financial conditions continue to ease, they will have to be more hawkish,” Luzzetti said.
While financial conditions have tightened a lot since the Fed began signaling its intention to confront inflation, some credit costs have gotten cheaper in the last few days.
Societe Generale strategist Manish Kabra watches what he calls “Dr. Junk,” or the spread of junk bond yields over Treasuries, to assess how much wrenching the Fed will have to do on markets to crimp demand and whip inflation.
That spread has widened to at least 800 basis points every time the economy has gone into a recession. It got up to 480 basis points but has recently narrowed to 400 basis points, as investors revive the idea of a soft-landing for the economy where growth and inflation slow without crushing employment.
“The recent improvement in credit conditions is mostly because the Fed has provided clarity to the market as what they would be doing almost until September,” Kabra said, allowing investors to focus on fundamentals.
Nonfarm payrolls increased 390,000 last month and the unemployment rate held at 3.6%, a Labor Department report showed Friday, assuaging any concerns that the economy was in a steepening slowdown.