The new Federal Reserve Chair, Kevin Warsh, has a fundamental difference in using data to adjust the fed funds rate.
Ex-Fed Chair Powell said that the Fed wants to target a “neutral” Fed funds rate called r* that neither stimulates nor slows the economy. The focus on r* had been Fed policy for decades. The problem is that r* cannot be observed in the real world—it can only be estimated by theoretical models that often change or prove inaccurate. And adjusting the fed funds rate because it’s higher or lower than r* may not work on the important interest rates in the real economy, such as the 10 year Treasury or mortgage rate.
Fed Chair Warsh has specifically rejected r*. Warsh asserts that what actually drives economic activity isn’t just the overnight federal funds rate relative to a theoretical r*, but how financial markets interpret and pass through that policy.
Borrowing costs for the real economy are dictated by mortgage rates, corporate bond yields, credit spreads, stock market valuations, and the US dollar. I track these in the Control Panel using the Chicago Fed’s National Financial Conditions Index (NFCI), which provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.
Important interest rates can loosen and tighten independently of the Fed. These are real-world financial variables that can dramatically impact each other even if the Fed does nothing - or acts opposite to the markets.
Warsh has argued that real-world financial conditions—mortgage rates, corporate bond yields, equity valuations, credit spreads, and the U.S. dollar—are the true transmission mechanism of monetary policy.
The Fed has created a model called the “FCI-G index.” ( Financial Conditions Impulse on Growth (FCI-G)). Using real-world inputs, not theory, the FOMC evaluates whether cumulative market movements are actively acting as a drag or a tailwind to GDP growth.
The word “Impulse” is Fed-speak for the rate of change (first derivative) of the financial level in the model. If the markets have adapted to a specific level (whether low or high on a historic basis) and there is no change in other market variables then the Impulse would be zero.
If stock markets rally, credit spreads narrow, and long-term yields fall, financial conditions ease—creating a positive impulse that stimulates growth, even if the Fed funds rate itself remains high.
Conversely, if broader market conditions tighten, they act as a drag on growth.
This is a much more complex but also more realistic model of what actually happens in the markets.
The index relies exclusively on seven market observables:
Federal funds rate
10-year Treasury yield
30-year fixed mortgage rate
BBB corporate bond yield
Dow Jones Total Stock Market Index
Zillow Home Price Index
Nominal Broad Dollar Index
METARs will immediately notice that the index components include direct observables which are dependent variables. The index doesn’t include independent variables such as the huge federal deficits which pump money directly into consumer pockets and stimulate consumer spending and inflation.
The Financial Impulse Growth Index measures the cumulative effect of changes in key indicators on the financial environment and quantifies this effect as the impact on GDP growth in the coming year. The difference between the one-year and three-year versions is that the period represents only the change in the past year. Positive values represent headwinds (harmful) to GDP growth and negative values represent tailwinds (helpful). For example, 1% means that financial conditions will have a 1% drag on GDP growth over the next year.
Using Impulse (the change in economic growth) instead of r* is a paradigm shift. If the Fed sees that the Impulse is for tail winds propelling economic growth (as it is right now) the Fed will feel free to raise the fed funds rate to tamp down inflation since many other factors are feeding into economic growth.
The NFCI tells us if stress is high on a weekly basis (e.g., +0.50 standard deviations), but it cannot directly tell us what that means for GDP. The FCI-G (monthly) translates financial moves directly into percentage points of macroeconomic impulse [change in GDP growth] (e.g., “Financial conditions will act as a 0.75% drag on GDP growth over the next 12 months”).
The FOMC decision to increase the fed funds rate by 0.25% last week was unanimous. They should have done that months ago, based on the Fed’s own failure to control inflation to their chosen goal of 2% for the past 5 years. The market expected it and the Fed followed the market.
I think that the rise in long-term bond yields would have spiked higher if the Fed had not raised the fed funds rate. Their credibility would have gone into the toilet.
Here is the FCI-G based on the Fed’s data up to 7/31/2026. Financial conditions predict a stimulus of 0.58% on GDP over the next year.
Because the FCI-G indicates a -0.58% stimulus (tailwind) to GDP growth over the next 12 months, the market itself is currently doing the work of easing financial conditions. When financial markets generate their own tailwinds—via equity rallies, narrow credit spreads, or resilient home prices—the policy rate must remain higher just to maintain a neutral overall economic posture.
Chicago Fed’s National Financial Conditions Index (NFCI), which provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems is very loose and stable.
The entire Treasury yield curve popped up after the Fed raised the fed funds rate, especially in the 2 to 10 year durations. The 10 YT hit 5%. If this doesn’t fall back the hit to the federal deficit will be hard.
The SPX and NAX have been in a holding pattern for several weeks. The Fear & Greed Index is in Fear. The stock market is still in its bubble.
Oil, gasoline, diesel and natgas are all trending up. USD is in its channel but Bitcoin suddenly popped. Gold, silver and copper seem to have stabilized but it’s too soon to tell.
The Atlanta Fed’s Third-Quarter GDPNow Estimate for 2026:Q3 is 5.3%, a stunning growth rate that will be inflationary if productivity doesn’t grow faster than its recent rate.
Rising Treasury yields will pressure many companies along with rising input costs (especially fuel). On the other hand, the financial situation is still very loose, which provides a tail wind to the economy.
The METAR for next week is cloudy.
Wendy
