Pro Perspectives 1/23/24






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January 23, 2024

In my note yesterday, we talked about the growth potential of the economy that is being strangled by a Fed that is overly tight.

With that, let’s revisit the Fed’s new financial conditions index, which gauges the impact of financial conditions on future economic growth.

Remember, this index is designed to incorporate the lags of monetary policy, and project (in this case) one-year forward what the impact will be on real GDP growth.

They just made an update to the index last week.  Let’s take a look …

In this chart above, if the line is above zero, it represents tight financial conditions, which project a drag on economic growth (from restrictive policy).  If it’s below zero, it’s a boost to growth (stimulative policy).

As you can see, based on the Fed’s formula, which factors in the current Fed Funds rate, the 10-year yield, the 30-year fixed mortgage rate, the lowest investment grade corporate bond rate, the DJIA stock market index, the Zillow house price index, and the value of the dollar, the Fed’s new index projects about a 1/2 percent drag on economic growth one-year forward.

So, despite the run-up in stocks over the past couple of months, and slide in bond yields, financial conditions remain historically very tight.

And if we look back at these moments (denoted in the chart) where financial conditions were historically very tight, every moment was soon followed with some form of Fed easing (either rate cuts, QE, or in the case of 2015-2016, removing projected rate hikes).

There is one exception.

The 1994-1995 period, where the Fed continued raising rates into a low inflation, slow economic recovery.

It was a mistake.  By July of ’95, they started cutting rates, and set into motion a boom-time period for growth and stocks.

The economy went on to average 4.5% quarterly annualized growth through the end of the 90s.  And stocks put up five big, double-digit return years, averaging 26% per annum.

What other similarities does the current environment have with this mid-to-late 90s period?

A technology revolution, and a (related) productivity boom.  The mid-90s came with the commercialization of the internet.  And now we have the commercialization of generative AI.