Higher U.S. Real Borrowing Costs Signal Tighter Financial Conditions

Over the past nineteen months, the Federal Reserve has raised the federal funds rate to its highest level in twenty two years. The Fed’s goal is to return inflation to its 2% target. By raising its policy rate, the Fed tightens financial conditions – raising the overall cost and availability of credit to households and businesses – in order to slow economic activity. 

But how are financial conditions measured? Households and businesses face an array of borrowing costs. One way is to aggregate the information across a number of different indicators to come up with a summary measure. Financial conditions indexes (FCIs) do just that and can be a useful tool for observing changes in broad financial conditions. However, while FCIs are good at capturing the impact of increased risk aversion and periods of financial stress, they do not always capture more subtle movements in borrowing costs, especially in an otherwise resilient economic environment. Indeed, some aggregate measures of financial conditions have eased recently, creating confusing signals in an environment of ongoing increases in interest rates. 

An alternative approach to measuring financial conditions is to look at changes in borrowing costs, adjusting for inflation. Looking at both real corporate and household borrowing rates, there is little doubt that financial conditions have tightened. These have had a notable impact on interest sensitive sectors of the economy, especially demand for housing. While the Fed's "higher for longer" rhetoric has pushed up real borrowing costs, the continued resilience in economic activity suggests that financial conditions may have to tighten even further (Chart 1).

Financial Conditions Indexes Reflect Financial Stress but Not Necessarily Borrowing Costs

FCIs, which encompass a vast number of financial and economic variables into a single metric, have become popular tools for economic forecasters and policy makers. FCIs capture activity from several different financial markets. They also provide a timely gauge of underlying stress in financial markets. 

Financial conditions have been tightening over the past two years. The TD Economics U.S. Financial Stress Index and the Federal Reserve Bank of Kansas City's U.S. Financial Stress Index began showing signs of tightening in late 2021, as financial markets began anticipating the withdrawal of the Fed's pandemic-era monetary stimulus (Chart 2). Both indexes increased again in March 2023, in response to the stress in the banking sector, but have since subsided. 

While FCIs have been useful for monitoring developments in financial markets and the broad economy, they may not adequately reflect the borrowing costs faced by businesses and households. This has been highlighted by the fact that borrowing costs have continued to increase, even as some FCIs have eased. With the Fed's policy actions aimed at slowing demand, a more detailed discussion of the costs faced by borrowers is helpful in gauging the appropriate path forward for the Fed. 

Fed's Actions Are Reflected in Moderating Inflation and Inflation Expectations 

The Federal Reserve first began raising its policy rate in early 2022, but the real fed funds rate – adjusted for inflation – did not move into positive territory until the first quarter of 2023 (Chart 3).

Fortunately, the aggressive actions of the Fed have coincided with a slowing in observed inflation. After peaking at 9.1% year-on-year (y/y) in June 2022, Consumer Price Index (CPI) inflation currently sits at 3.7% y/y. Just as important, inflation expectations, which increased in tandem with inflation, have declined markedly. According to the Federal Reserve Bank of New York's survey of consumer expectations, one-year ahead expectations currently sit at 3.7%, and are almost 1% above their long-run average. Three-year ahead expectations have fallen to 3.0% and are marginally above their long-run average (Chart 4).⁷

The decline in inflation expectations has also pushed up real borrowing costs. One way to see the increase is in Treasury Inflation Protected Securities (TIPS), securities whose principle and coupon payments are adjusted for inflation. TIPS have increased markedly since the end of 2021, with the 2-year and 10-year TIPS rising 533 bps and 354 bps, respectively. TIPS are currently hovering at levels last seen in 2009. With a slower pace of rate cuts now expected next year, and inflation expectations continuing to fall, real interest rates look to become more restrictive.

Higher Rates Have Slowed Activity in Interest Sensitive Areas

Real corporate yields have also increased markedly since the end of 2021, with the inflation-adjusted BBB yield rising by 336 bps. In the non-investment grade space, the inflation-adjusted double-B and single-B rates have increased by 374 bps and 391 bps, respectively (Chart 6).

There is evidence that the Fed's actions are slowing activity. Corporate bond issuance has fallen sharply from its pandemic-era surge when firms locked into low borrowing costs (Chart 7). Moreover, business capital spending intentions, as indicated by the Federal Reserve Bank of Chicago's capital spending survey, have declined sharply beginning in the second half of 2021. 

The impact of higher rates has been most pronounced in the housing sector. The 30-year conventional mortgage rate currently sits at 7.8% and is hovering at its highest level since 2000 (Chart 8). When adjusting mortgage rates for inflation – real mortgage rates are also at levels last seen in 2000. The swift increase in mortgage rates has eroded housing affordability, resulting in mortgage demand falling to its lowest level since 1995.⁸

Pockets of Strength Have Emerged Despite Rising Borrowing Costs

While housing demand has plummeted, a lack of inventory of homes for sale has limited home price declines. Still, with housing affordability continuing to deteriorate, home prices are likely to move lower over the next year (link). 

Consumer spending, meanwhile, has been a pilar of strength for the economy, benefitting from savings accumulated over the pandemic. However, much of these savings have now been drawn down and spending is likely to slow (link) materially over the next year.

Business investment (link), on the other hand, will continue to be supported by fiscal policy, and is likely to maintain some strength over the next year. Should fiscal supports continue to give support to economic growth, the Fed may be forced to adjust its monetary policy stance to further tighten financial conditions.

The Fed Still Pondering Lags and Neutral Rates 

Incoming economic data will continue to be central to the Fed's calculus in deliberating its next policy move, but policymakers are also focused on the "long and variable" lags of monetary policy. Econometric models have estimated that this lag could range from 12-24 months. However, shifts in policy tools in the post-GFC era, including the use of forward guidance, may have shortened these lags.¹⁰ One implication of shorter lags is that the Fed's previous rate hikes would have already fed through to economic activity at this point, which given ongoing demand strength, suggests additional tightening would be required.

Another important consideration is the neutral rate of interest – the interest rate that neither stimulates nor slows economic activity. As we discussed in a recent piece (link), structural factors such as climate change and deglobalization have likely pushed the neutral rate higher. A higher neutral rate means the Fed has to do more to slow the economy. This may be reflected in the Federal Reserve’s FIC-G index, which has fallen from its peak at the end of 2022, signaling that previous changes in financial conditions could have a more muted impact on real GDP than those earlier in the cycle (Chart 10).

Bottom Line

Financial conditions are closely monitored by the Fed as they transmit monetary policy to the real economy. While some measures of financial conditions have eased in recent months, the rise in real borrowing costs is undeniable and a sign that the medicine is working. Higher borrowing costs have, in turn, reduced demand in interest rate-sensitive sectors of the economy. 

At the same time, the resilience in overall economic activity suggests that the dosage may yet have to be tweaked. Fiscal supports are counteracting some of the impact and structural changes to investment demand may require higher interest rates than previously thought. While the Fed's actions to date have tightened financial conditions, they may have to go just a bit further in order to ensure inflation continues to move toward its 2% target.