Bao Dandan/Zuma Press

Federal Reserve Chairwoman Janet Yellen gave a nod to tightening “financial conditions” in her prepared remarks before Congress, reinforcing the views of a broad swath of investors and analysts, as well as some central bankers.

What are these financial conditions of which she speaks?

When the Fed raises interest rates, its goal is typically to lift borrowing costs to keep an exuberant economy from overheating. The central bank has only lifted rates once on Ms. Yellen’s watch–by a quarter of a percentage point in December–but the official rate isn’t the only way to tighten financial conditions. The market can do some of the heavy lifting as well.

The market-based tightening seems to be running ahead of the Fed’s plans, and Ms. Yellen now suggests this could be a problem if it continues. While some tightening is good, too much risks dampening the economy.

“Financial conditions in the United States have recently become less supportive of growth,” Yellen said in her testimony. “These developments, if they persist, could weigh on the outlook for economic activity and the labor market.”

That echoes comments made last week by William Dudley, president of the Federal Reserve Bank of New York.

There are a number of ways to look at financial conditions beyond the official fed funds rates. One is the so-called Wu-Xia shadow fed funds rate, which takes a look at how monetary conditions change even as the rate is confined to a particular range. The “shadow” rate was negative during much of the post-crisis recovery, but it’s been coming back to normal, as the chart below, from DoubleLine Capital shows:

Wu-Xia Shadow Fed Funds Rate

DoubleLine, Bloomberg

As DoubleLine portfolio manager Sam Garza noted in a report Monday, that indicator suggests tightening began as early as June 2014, and it’s been largely in line with past tightening cycles. That’s happened as the dollar strengthened, oil prices fell, and high yield bond spreads widened. It’s also picked up recently.

The Wu-Xia gauge “shows that we have seen 103 basis points of tightening since September,” according to research last week by David Rosenberg, chief economist and strategist at Gluskin Sheff and Associate.

Many of the big banks create their own such gauges. A Goldman Sachs financial conditions index also shows that conditions began tightening in mid-2014, and picked up in December. The bank’s economists, led by Jan Hatzius, wrote last week, “recent comments suggest that policymakers see the tightening in financial conditions as excessive, with potential implications for growth and the path for policy later this year.”

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