By Michael S. Derby
Oct 28 (Reuters) - One issue dividing Federal Reserve officials over whether more interest rate hikes are needed as soon as this week is just how much weight to put on the loose financial conditions that many outside the US central bank see as a key driver of inflation in an accelerating economy.
Financial conditions — denoted by things like short- and long-term borrowing costs and stock prices — are a key variable because the changes the Fed makes to the cost of short-term credit rely on markets to translate them to broader borrowing costs.
On balance, a central bank that is on a rate-hike path to combat half a decade of above-target inflation would likely boost interest rates at the two-day meeting that is scheduled to conclude on Wednesday.
But guidance from key officials suggests a majority of Fed policymakers will support leaving the central bank's benchmark interest rate unchanged after unanimously agreeing to lift it by a quarter of a percentage point to the 3.75%-4.00% range in September. Investors expect a rate hike at the December 8-9 policy meeting.
"Some people on the Fed have a financial conditions framework and some people don't," said William Dudley, who led the New York Fed from 2009 to 2018. Fed Chairman Kevin Warsh "seems to think that financial conditions are important," but that sense is "not really ingrained" in terms of how "the Fed thinks about monetary policy" as an institution, Dudley said.
Officials flagged by Dudley as sensitive to market conditions are those many believe are likely to dissent in favor of higher rates, including the Cleveland and Dallas Fed presidents and potentially the head of the Minneapolis Fed.
Those three policymakers dissented over the decision to leave rates unchanged in July, which was the second meeting of the Warsh-led era. Meanwhile, officials such as New York Fed President John Williams are more focused on economic data. Williams was one of the key voices who boosted markets' bets that the Fed would hold rates steady this week.
'GOING FULL STEAM AHEAD'
Understanding financial conditions is "part of my framework. It's something that I look at because I think it's really hard to know what neutral is" when it comes to setting central bank rate policy, Cleveland Fed President Beth Hammack said earlier this month.
Even with real-world borrowing costs having gone up, "most of what I'm hearing in my district is that they're going full steam ahead" and "when I look at financial conditions broadly, to me they don't seem restrictive" and they likely need to be to help the Fed get inflation back to its 2% target, Hammack said.
Dudley agrees with the financial focus.
"The US economy doesn't run on short rates; it runs on long rates, it runs on the stock market valuation, and it affects the household wealth," he said. "If you just focus on short-term rates and don't care about how that's influencing all these other factors, you're going to misjudge the stance of monetary policy."
Private-sector economists generally agree that financial conditions are not in a place to help bring down price pressures.
Goldman Sachs' closely watched financial conditions index for the US has tightened a bit since the Fed hiked rates on September 16, but is still close to where it was at the start of the year despite the more hawkish monetary policy path. Meanwhile, a survey of investors by Deutsche Bank showed 42% of respondents deemed financial conditions as "moderately accommodative," with only 15% saying they were restrictive.
Analysts at Piper Sandler think monetary policy is likely misaligned with what the central bank wants from price pressures. "The Fed is still accommodative," the firm said, noting that an effective 3.9% federal funds rate was supporting growth and cushioning the economy from 5% bond yields, as reflected in banks' easing lending standards.
Former Philadelphia Fed President Patrick Harker, now a professor at the University of Pennsylvania's Wharton School, said getting to the bottom of financial conditions is a "complicated story" in which investment in the tech sector is very strong but not so elsewhere. As a result, he views the overall state of financial conditions as closer to neutral.
Evercore ISI analysts said it would be better if the Fed had more clarity over financial conditions.
"Warsh's focus on financial conditions without a well-defined FCI (Financial Conditions Index) framework is a vulnerability," they said in a note on Monday.
In terms of Warsh's approach at the post-meeting press conference on Wednesday, "we think he will suggest somewhat tighter FCI could help extend the AI boom, though that could sound more persuasive to economists than investors," the Evercore ISI team said.
(Reporting by Michael S. Derby; Editing by Paul Simao)