I’ve been on (and on) about the Fed’s financial conditions reflexivity problem.

The dynamic is easy enough to grasp. I’ll briefly recapitulate.

The Fed needs financial conditions to remain a semblance of tight in order to coax the inflation genie back in the bottle, but not so tight as to make a hard landing (or a recession) a foregone conclusion either through too much demand destruction or some manner of financial crisis.

When financial conditions tighten such that the odds of an “accident” are deemed to be perhaps higher than warranted or, relatedly, if developments in financial conditions are seen as sufficient to obviate the need for additional policy rate increases, the Fed might seek to soften its tone. But in doing so, the Fed risks engendering easier financial conditions as markets rapidly incorporate the read-through of a more conciliatory policy stance.

This was a problem throughout the hiking cycle (e.g., in July of 2022 and also around this time last year), and it’s back in focus following Fed officials’ messaging shift in October, the enshrining of that shift into the November policy statement and the subsequent cross-asset rally which worked at cross-purposes with the Fed’s desire to preserve at least some of the late-summer tightening impulse.

Jerome Powell went to great lengths in the press conference this month to emphasize that for tighter financial conditions to impact policymaking, any tightening would need to meet two conditions: It couldn’t be based on expectations for the funds rate (it wouldn’t make any sense to cite expectations for a higher policy rate as an excuse for not raising the same policy rate) and it’d need to be persistent. The first condition was met (tighter financial conditions in August, September and October were in no small part attributable to a higher term premium, higher real rates, a stronger dollar and lower stocks as collateral damage), but three weeks on, we can definitively say that the “persistent” condition isn’t — met, I mean.

Some readers have asked if the Fed actually cares about indexes of financial conditions, where that means Bloomberg’s gauge or Goldman’s. I can’t answer that question. The figure below is the Chicago Fed’s gauge and while the same question applies (i.e., Does the Fed care?) it’d be reasonable to suggest that someone at the Fed (even if it’s just staff) looks at the gauge once in a while considering it’s a product of the Fed.

The easing that accompanied this month’s “everything rally” is readily apparent on the right-hand side (see the black line’s sudden inflection lower).

Note that on the adjusted version of the Chicago’s Fed’s gauge, conditions are now as loose as they were around the time the Fed first hiked.

On Tuesday, BNY Mellon’s John Velis took a few minutes to editorialize around the Fed’s reflexivity problem, citing the Chicago Fed index. “This cannot be what the Fed had in mind just a few weeks ago at the FOMC meeting,” he wrote, of the sharp easing observed over the past four weeks. “If one leans on FCIs to make policy, one risks moving them in the opposite direction than desired.” Indeed.

Velis doesn’t think additional rate hikes are likely, though. Or at least not imminently. “What it does mean, we think, is that Fed rhetoric and its overt bias will be hawkish,” he said, adding that BNY Mellon doesn’t expect the first rate cut until July, or perhaps even September. The Fed, Velis went on, will likely “push back against the notion of rate cuts so early, in part as an effort to reestablish tighter financial conditions.”