As financial conditions tighten, Fed may have to run to stay in place
Seemingly lost in the talk about whether or not the Federal Reserve should ease again is the idea that financial conditions have tightened and the U.S. central bank may have to offer additional stimulus if only to offset that tightening. Writes Goldman Sachs economist Jan Hatzius:
Alongside the slowdown in the real economy, financial conditions have tightened. Our revamped GS Financial Conditions Index has climbed by nearly 50 basis points since March, as credit spreads have widened, equity prices have fallen, and the U.S. dollar has appreciated.
Goldman’s new GS Financial Conditions Index is based on the firm’s simulations with a modified version of the Fed’s FRB/US Model. It includes credit spreads and housing prices and has a closer relationship with subsequent GDP growth than the previous version of the index, the firm says. A 100-basis-point shock to the GSFCI shaves 1-1/5 percent from real GDP growth over the following year. Still, it’s not quite as bad as it sounds:
Some of this tightening is clearly a reflection of the weaker U.S. economic numbers, so we should not ‘double-count’ it as a negative impulse to growth. And some of it has been offset by the fall in oil prices, which has kept the ‘oil-adjusted’ GSFCI from tightening nearly as much.
The intensification of the European crisis as concern about the Greek election and Spanish banking system mounts accounts for up to half of the tighening in the GSFCI since April, Hatzius said. “We estimate this could shave 0.2 to 0.4 percentage points from U.S. GDP growth over the next year.”
Goldman Sachs expects U.S. growth to average slightly less than 2 percent over the next year, with Q1 2013 the weakest quarter at just 1.5 percent “due to the likely fiscal tightening” then.
Talk of a possible rescue of Spain’s banks wafted through global financial markets before the weekend. The “hit” from Europe to U.S. growth could increase or decline, but the risks are “skewed to a worse outcome than our current baseline,” Hatzius said.
If financial conditions have tightened enough, the Fed might have to ease just to maintain the status quo.