By Yoruk Bahceli

(Reuters] – Stock market investors already face double-digit losses in this year’s first quarter. As the realization sinks that the U.S. Federal Reserve plans to increase financial restrictions to combat red-hot inflation, they must be ready for even more.

Financial conditions, which measure the ease with which households or businesses are able to access credit, is crucial in determining how monetary policy affects the economy. Jerome Powell, Fed chief, reiterated Wednesday that he would be closely monitoring them.

These factors have an effect on future growth – Goldman Sachs’ (NYSE:) forecasts that a 100-basis point tightening in its proprietary Financial Conditions Index (FCI) -which includes credit, rates and equity levels – will impede growth by one percent over the next year.

Goldman’s, the Chicago Fed and IMF indexes show that financial conditions have improved significantly but are still relatively loose historically. This is a testimony to how much stimulus was unleashed in order to support economies during the Pandemic.

Sven Jari Stehn (chief European economist, Goldman Sachs) estimates that the U.S. bank’s financial conditions index needs to tighten slightly more in order for the Fed achieve a “soft landing”, which is i.e. To slow down growth, but not too much.

Goldman’s U.S. FCI stands at 99 points, 200 bps less than the beginning of the year and is the tightest since July 2020. On Thursday, shares dropped and dollar reached two-decade highs. 10-year bonds yields were above 3%. Conditions became tighter by 0.3 point.

However, they are historically still loose.

Stehn stated that “the Fed needs to basically halve [the jobs-workers gap] to attempt to bring wage growth back into a more normal range.”

They must reduce the growth rate to around 1% in a period of time. This means that you need to stay below the trends for a number of years.

For June and July, 50 bps will be raised. After that 25 bps increments are planned until rates reach 3%. He said that 50-bps increases may be continued by the Fed if inflation and wage growth do not slow down enough.

Market bets suggest that FCI’s looseness is puzzling, given the Fed’s promise to raise rates by 3% next year while reducing its bond holdings, sharply increasing Treasury yields, and plunging stocks.

The stock is 20% below its pre-pandemic peak. The wealth effect is believed to be responsible for household spending being supported by equity prices.

However, this could be changing – The Fed stopped growing its balance in March, and will now start to reduce it beginning June. This is at a monthly $95 Billion rate. They are embarking on quantitative tightening.

Michael Howell from Crossborder Capital noted that U.S. equity has been declining due to a 14% decrease in the Fed’s effective liquidity provision since December.

He estimates, based on pandemic-time stock rallies and recent falls, each monthly reduction could knock 60 points off the S&P 500.

Howell stated that the stock market is “certainly not discounting any further decrease in liquidity, but we know this’s going to occur.”

UNFAMILIAR TTERRITORY

It is unclear if the Fed has the ability to tighten market conditions enough to lower prices, but not too much so that markets and growth are severely affected.

Catherine Mann, Bank of England policymaker noted that there is a danger that the huge balance sheets of central banks could have impeded transmission of monetary policies into financial conditions.

The Fed might need to take a more aggressive stance if this is the case.

Mike Kelly, global multi-asset head at PineBridge Investments noted that QT episodes in the past were smaller. Therefore, “we are entering an environment unlike any one’s seen before.”

The stock market plunged 10% in the QT exercise of 2013 and 2018, prompting the Fed’s tightening.

But those used to relying on the Fed “put” – the belief it will step in and backstop stock markets – should watch out; Citi analysts reckon this put may not kick in before the S&P 500 endures another 20% fall.

Patrick Saner (OTC), head of macro strategy for Swiss Re, said that “where you have 8.5% inflation…the strike price of central bank put option are a lot lower than they used to be.”