GOLDMAN SACHS: The market is underestimating the Fed in one critical way

The Federal Reserve has expressed concern about tight financial conditions and how it puts pressure on economic growth.

Indeed, when the popular measures of financial conditions tighten sharply, it’s common for market pundits to conclude that the odds of a near-term rate hike from the Fed are falling.

However, Goldman Sachs economists warn that the “markets may be underestimating Fed officials’ tolerance for tighter financial conditions over time.”

What the Fed said about tight financial conditions

Among other things, tight financial conditions are reflected in surging interest rates, widening credit spreads, tighter lending standards, and falling stock prices (^GSPC).

Financial conditions tightened substantially after the Fed hiked rates on December 16.  And the Fed addressed it at its January Federal Open Market Committee (FOMC) meeting.

“While acknowledging the possible adverse effects of the tightening of financial conditions that had occurred, most policymakers thought that the extent to which tighter conditions would persist and what that might imply for the outlook were unclear, and they therefore judged that it was premature to alter appreciably their assessment of the medium-term economic outlook,” revealed the Fed in the minutes of its January meeting.

There was no rate hike at that January meeting, and financial conditions have since eased.

Most economists believe that heightened concerns about economic growth and elevated volatility (^VIX) in the financial markets will keep the Fed from hiking interest rates when FOMC meets next Tuesday and Wednesday.

For the Fed, one of the big risks continues to be that they raise rates too quickly, exacerbating volatility in the markets, which would once again result in the significant tightening of financial conditions.

Goldman Sachs thinks the markets are underestimating the Fed

“Beyond next week’s meeting, we think markets may be underestimating Fed officials’ tolerance for tighter financial conditions over time,” Goldman Sachs’ Zach Pandl and Jan Hatzius said in a note to clients on Friday. “In fact, we expect that financial conditions will need to tighten moderately over the next year to bring employment growth to a trend pace, which probably requires a steeper funds rate path than currently priced in the bond market.”

This is all a bit counterintuitive for anyone who assumes any amount of economic growth is good news. However, we need to keep in mind two things: 1) monetary policy continues to be very loose, and 2) economic growth that’s too hot and unemployment that’s too low put the economy at risk of overheating and inflation at risk of surging. An overheated economy is bad news because the inevitable downturn is always much more painful.

“To prevent financial conditions from tightening, the FOMC would indeed need to raise rates no faster than markets anticipate (all else being equal),” Pandl and Hatzius wrote. "But if faced with a tradeoff between steady markets and a smooth landing for the economy, Fed officials would surely choose the latter.”

In other words, the cost of stability in the economy in the long-term is more volatility in the markets and the economy in the near-term.

Pandl and Hatzius expect the next rate hike to occur at the June 14-15 FOMC meeting. But they also note, “action at the April 26-27 meeting is not inconceivable.”