Nearly 20 years ago—when I was working in the private sector—my colleagues and I introduced an index of financial conditions.2 I believe that my long-standing focus on financial conditions has, over time, helped me become a better economic forecaster. And, I am pleased that economists and analysts increasingly incorporate financial conditions into their assessments of the economic outlook. As I will argue, financial conditions in the United States play an important role in influencing economic conditions. Because movements in financial markets are a major factor influencing broader financial conditions, it is necessary to understand how financial market developments can affect the economic outlook and, therefore, the appropriate setting of monetary policy. But, this story gets more complicated, as the setting of monetary policy, in turn, affects market developments and financial conditions. This two-way feedback is an important feature of the interaction between financial conditions and monetary policy. To begin, let me be clear about what we mean by “financial conditions.” Focusing on the United States, financial conditions can be broadly summarized by five key measures: short- and longterm Treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices. Although many other measures and prices can also be included in one’s assessment, I think these five are the most essential.3 In the conduct of monetary policy, the FOMC does not have targets for either specific components of financial conditions or for financial conditions more broadly.
The rise in short-term rates was offset by a decline in long-term yields, a rise in equity prices and narrower credit spreads. In contrast, there have been times when financial conditions tightened even as the FOMC reduced short-term interest rates. For example, consider what happened during the heart of the financial crisis. Even as the FOMC lowered the federal funds rate in the fall of 2008—eventually hitting its effective lower bound that December—credit spreads widened sharply, household and business loan underwriting standards tightened sharply, liquidity in many financial markets dried up, and the U.S. stock market plummeted. Financial conditions tightened despite the aggressive easing of monetary policy during this period. There are many explanations for why the relationship between the federal funds rate and financial conditions is so variable. Without being exhaustive, let me highlight three. First, animal spirits in financial markets wax and wane, pushing asset values up or down in a manner that can more than offset the effects of movements in short-term interest rates. The movements in many financial markets following last year’s presidential election are a notable example of this phenomenon. Second, domestic financial conditions are influenced by what happens abroad. If the monetary policy of major U.S. trading partners becomes easier relative to policy in the United States, then it could lead to a dollar appreciation that would weigh on U.S. trade performance, all else equal. Third, financial instability and stress can cause risk-averse investors to increase their demand for safe assets.