In search of the elusive soft landing.

“So, what am I worried about?” New York Fed President William Dudley, who is considered a dove, asked rhetorically during a speech on Thursday at the Securities Industry and Financial Markets Association in New York City. “Two macroeconomic concerns warrant mention,” he continued. And they are:

One: “The risk of economic overheating.” He went through some of the mixed data points, including “low” inflation, “an economy that is growing at an above-trend pace,” a labor market that is “already quite tight,” and the “extra boost in 2018 and 2019 from the recently enacted tax legislation.”

Two: The markets are blowing off the Fed. He didn’t use those words. He used Fed-speak: “Even though the FOMC has raised its target range for the federal funds rate by 125 basis points over the past two years, financial conditions today are easier than when we started to remove monetary policy accommodation.”

When the Fed raises rates, its explicit intention is to tighten “financial conditions,” meaning that borrowing gets a little harder and more costly at all levels, that investors and banks become more risk-averse and circumspect, and that borrowers become more prudent or at least less reckless – in other words, that the credit bonanza cools off and gets back to some sort of normal.

To get there, the Fed wants to see declining bond prices and therefor rising yields, cooling equities, rising risk premiums, widening yield spreads, and the like. These together make up the “financial conditions.”

There are various methods to measure whether “financial conditions” are getting “easier” or tighter. Among them is the weekly St. Louis Fed Financial Stress Index, whose latest results were published on Thursday.

The Financial Stress Index had dropped to a historic low of -1.6 on November 3, meaning that financial stress in the markets had never been this low in the data series going back to 1994. Things were really loosey-goosey. On Thursday, the index came in at -1.57, barely above the record low, despite another rate hike and the Fed’s “balance-sheet normalization.

And this rock-bottom financial stress in the markets is occurring even as short-term interest rates have rocketed higher in response to the Fed’s rate hikes, with the two-year Treasury yield on Thursday closing at 1.96% for the third day in a row, the highest since September 2008.

The two-year yield and the Financial Stress Index normally move more or less in parallel. But in July 2016, when it became clearer that the Fed would finally stop flip-flopping and start raising rates, the two-year yield began to rise sharply and recently began to spike. But the Financial Street Index fell.

This chart of the St. Louis Fed’s Financial Stress Index (red, left scale) and the two-year Treasury yield (black, right scale) shows this gaping crocodile-jaw disconnect:

The Financial Stress Index is made up of 18 components. A value of zero represents “normal” financial market conditions. Values below zero indicate below-average financial market stress. Values above zero indicate higher than average stress.

So with the economy facing the risk of “overheating,” and with markets doing the opposite of what the Fed wants them to do – namely cooling off – Dudley warned:

This suggests that the Federal Reserve may have to press harder on the brakes at some point over the next few years. If that happens, the risk of a hard landing will increase. Historically, the Federal Reserve has found it difficult to achieve a soft landing – especially when the unemployment rate has fallen below the rate consistent with stable inflation.

In those circumstances, the Federal Reserve has been unable to both push up the unemployment rate slightly to a level that is consistent with stable inflation and avoid recession.

It was a shot before the bow – one of many – for the markets to start paying attention to the Fed. Monetary policies have no impact unless markets believe in them, react to them, and thus effectively implement them. But this might be a lot to ask, after the Fed has spent years methodically and thoroughly destroying its own credibility by flip-flopping wildly at every market squiggle, first on tapering QE while it was still going on and then on raising rates.

Eventually markets fall in line. And if I read Dudley’s words correctly, he is worried that markets will fall in line too late, and only after the Fed has fired some big guns to get their attention, and then it might happen all at once, and the sudden adjustment in prices, yields, spreads, risk premiums, etc. might be too brutal for the economy to digest.

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