“At the highest level, monitoring financial conditions is critical because markets are forward looking, and expectations about the economy or what the Federal Reserve will do become priced into conditions and begin having an influence on the economy in real time,” said Hirt. “VFCI has been developed to incorporate a broad range of indicators, so it acts as a barometer to how overall financial conditions are behaving as opposed to individual data points such as mortgage rates, the 10-year Treasury yield, or Fed policy.” 

The VFCI jumped from an exceptionally accommodative level of –0.57 in July 2021 to a fairly restrictive 0.60 in May 2022. Positive VFCI values mean financial conditions are more restrictive than average, which could dampen future economic activity, while values below zero indicate conditions are more accommodative than average, which could support future economic activity.

What’s behind the sharp reversal? The second half of last year was a pivot point for the economy as it began to emerge from the pandemic and concerns mounted about persistent inflation and labor market shortages. As a result, the Fed changed its tone regarding conditions in the economy, and the market reacted. The change in VFCI reflects that shift.

The reversal is shown in the interactive chart below, where the index line rises sharply toward the end of the period. The chart also illustrates how restrictive financial conditions were during the depths of the global financial crisis in 2007–2009 and at the onset of the COVID-19 pandemic in 2020.

To see how each of the broad categories contributes to the overall VFCI, hover over a point in time in the graphic below or click on the broad categories to customize your view.

The underlying components of VFCI can be grouped into three broad categories:

• Lending rates, which affect mortgage rates and corporate borrowing;
• Equity valuations, which can exert a positive or negative wealth effect on households and influence corporate decision-making; and
• Cash rates, which primarily affect savings rates and investment decisions.

To see how each of these broad categories contributes to the overall VFCI, hover over a point in time in the graphic above or click on the broad categories to customize your view.  

Higher lending rates were the primary driver of the index recently moving into restrictive territory. The Fed and the markets both initially expected the rise in consumer prices in the wake of the COVID-19 pandemic to be transitory. Although unflattering year-over-year comparisons have faded, persistent supply chain bottlenecks, widespread labor shortages, and rising food prices have helped push consumer prices higher.

Energy prices have contributed, too. While the price of oil started on an upward trajectory in late 2020 alongside the rollout of vaccines and a brighter growth outlook, it has jumped roughly 70% from the beginning of 2022 through early March, although it has since given back some of those gains.

Together, these forces drove up the Consumer Price Index. It surged to 8.6% on an annualized basis in May, a level not seen since 1981.

The Fed’s pivot toward less accommodative monetary policy contributed to the rise in lending rates. In November 2021, the Fed started to taper its monthly bond purchases. In March 2022, it made its first short-term interest rate hike, significantly raising market-based expectations about the future path of Fed monetary policy. And in April, it unveiled a preliminary schedule for reducing its balance sheet. As price stability is one of its mandates, we believe the Fed will continue to do the hard work necessary to bring inflation back toward target levels.

Equity valuations took a hit with Russia invading Ukraine, adding to the tightening of financial conditions. As of the end of May, the broad U.S. stock market was down about 14% year to date.

It’s worth noting that equity valuations are one of the more volatile components in our VFCI as they can fluctuate significantly over even a short period of time. As Vanguard economist Adam Schickling notes, “Periods of tightening driven exclusively by equity events can often be short-lived, but all indicators have been moving in the same direction recently, which is historically a sign that the current tightening may be more likely to persist.”

With funding becoming harder to obtain and more costly, according to VFCI, we expect some impact on economic growth. A higher VFCI level has a dampening effect on spending, saving, and investment plans for both businesses and households.

“Our research suggests a sustained 0.2-unit increase in VFCI results in a minus 50 basis point deceleration in GDP growth rate over the subsequent four quarters,” said Schickling. “The impact from more restrictive financial conditions is reflected in our recently revised forecast for full-year GDP growth of around 2.0% in the U.S., a slower pace than the annual rate of 5.5% in 2021.”

The picture looks brighter further out. “The markets are likely to turn choppier in the near term as they adjust to more restrictive conditions,” said Hirt, “but ultimately, with a rise in interest rates, investors should see higher fixed income yields in the future.”