By Richard Leong
NEW YORK (Reuters) - Despite analysts' chatter that sluggish inflation may prevent the Federal Reserve from raising interest rates further soon, the rosy scene in financial markets might allow U.S. policy-makers to squeeze in another rate hike this year after all.
Wall Street stocks have been on a record tear, the U.S. dollar is tumbling at a pace not seen in 15 years, and long-term U.S. Treasury bond yields have fallen even though the central bank has raised its overnight borrowing costs four times in the past 19 months.
"The Fed has hiked two times this year and financial conditions have remained easy," said Jim Caron, portfolio manager at Morgan Stanley Investment Management in New York.
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In fact, financial conditions have rarely been looser.
Since the Fed first raised interest rates in December 2015, yields on bonds issued by the worst-rated U.S. companies have plunged from nearly 22 percent to 10.6 percent, Bank of America/Merrill Lynch fixed income index data shows <.MERH0A3>.
Those yields, a proxy for the borrowing costs of less creditworthy companies, are typically much higher, averaging 14.7 percent over the last 20 years.
Meanwhile, another measure of financial market stress compiled by the Federal Reserve Bank of St. Louis is around a three-year low, hovering near its lowest level ever.
These indicators suggest the Fed's rate hikes, and its stated intention to soon start winding down its $4.2 trillion bond portfolio, have hardly restricted access to cheap money.
In other words, financial conditions have eased even as the Fed has been trying to tighten them, suggesting policy-makers have plenty of leeway to raise interest rates again, even in the face of an inflation rate that remains stubbornly below the Fed's 2.0 percent target.
"The relentless easing of financial conditions - especially tighter credit spreads - 18 months after rate liftoff could be the Fed's new conundrum," said Shehriyar Antia, founder of New York-based Macro Insight Group.
"This certainly weighs on the minds of prominent (Federal Open Market Committee) members and offsets, at least somewhat, the recent decline in inflation," said Antia, a former senior policy analyst at the Federal Reserve Bank of New York familiar with the thinking of that bank's influential president, William Dudley, a permanent voter on the FOMC.
ON THE RADAR
Episodes of market volatility have delayed policy actions in the past.
In both 2013 and 2015 the Fed held off on earlier attempts to normalize monetary policy because market volatility had tightened financial conditions to an uncomfortable degree.
Looser financial conditions, on the other hand, gives Fed policymakers more room to move.
The Dow Jones Industrial Average <.DJI>, S&P 500 benchmark stock index <.SPX> and the Nasdaq Composite <.IXIC> have hit repeated all-time highs in recent weeks.
A key index that tracks the U.S. dollar against a basket of major currencies <.DXY> has fallen more than 8.0 percent so far this year, its worst showing through the first seven months in a year since 2002. That's a benefit for U.S. multinational corporations that generate significant overseas income in currencies gaining against the dollar.
Benchmark 10-year Treasury yields <US10YT=RR> are fractionally lower so far in 2017 and are effectively unchanged from December 2015 when the Fed first raised rates.
Credit spreads for corporate bonds, a measure of the premium investors demand for buying them instead of safer Treasuries, are less than half what they were 18 months ago, and have narrowed most for bonds of the weakest borrowers.
As a result U.S. companies can borrow cheaply and are competitive abroad, while consumers are seeing their wealth grow and can finance their purchases.
"There is a ton of room for the Fed to continue on a gradual path to normalize interest rates," said Jim Paulsen, chief investment strategist at The Leuthold Group in Minneapolis.
To be sure, Fed Chair Janet Yellen and others have expressed caution about the recent softening in inflation, pushing it further below from the Fed's 2.0 percent goal.
Some inside the Fed would like to see inflation rise further before raising rates again, and the Fed's FOMC in its statement on Wednesday appeared to flag a growing unease with the weak pricing trend.
The Consumer Price Index rose 1.6 percent on a year-over-year basis in June for its smallest rise since October 2016. It has missed analysts' forecast for four straight months.
Still, other key Fed voices, Dudley's among them, worry that not taking the chance now to push rates higher risks letting financial conditions get too easy, and risks asset price bubbles forming. Fed officials also see higher rates as giving them greater ammunition to fight the next economic downturn.
The tension between these camps is playing out in markets, too.
Interest rate futures <FFZ7><FFF8> imply a third rate hike in 2017 is seen as a coin toss, but Wall Street economists expect the Fed to start shrinking its $4.2 trillion bond portfolio later this year [FED/R], a move which could finally see financial conditions tighten without impeding economic growth.
"In shrinking the balance sheet by allowing Treasuries and MBS to roll off, the Fed will be taking a step that directly affects financial conditions, arguably without making a substantial difference for the economy," said Stephen Stanley, chief economist at Amherst Pierpont in Stamford, Connecticut.
(Additional reporting by Jonathan Spicer; Editing by Dan Burns)