By Ben Eisen 

Monetary-policy makers are coming to the grim conclusion that financial markets aren't letting them tighten financial conditions gradually.

The problem: The rise of the dollar over the past year and the swift retreat from risk in 2016 are raising the cost of funding and damping growth in the real economy more quickly and extensively than the Fed would like. The effects are significant enough that Federal Reserve Chairwoman Janet Yellen pointed to higher borrowing costs and the dollar in testimony before the Senate Banking Committee on Thursday.

"Financial conditions in the United States have recently become less supportive of growth," she said.

The Fed's goal in lifting interest rates in December was to gently bring them back to more normal levels after keeping them near zero since the financial crisis. The Fed has lifted its policy rate just that one time on Ms. Yellen's watch. But some economists track indicators to come up with a "shadow" measure of the Fed-funds rate. That has climbed significantly since mid-2014, when the U.S. central bank began winding down its bond buys.

To be sure, financial conditions still aren't excessively restrictive. While the tightening, if sustained, could cut into economic growth this year, it isn't accelerating at a pace that suggests a coming recession, according to Capital Economics.

Still, financial conditions, based on a series of market indicators, are as tight as they have been since the financial crisis, according to BlackRock.

One reason is the dollar.

When U.S. dollars become more expensive, it becomes more costly for those outside the U.S. to borrow in the currency. It also weighs on corporate sales and profits, giving companies less money to spend or invest. Apple Inc., for example, said last month that overseas revenue worth $100 in the last quarter of 2014 was now worth just $85.

The WSJ Dollar Index has dropped 2.8% in the past two weeks. But it has climbed 20% over the last two years.

"Foreign-exchange translation will continue to be a headwind, with most of our key international markets' currencies expected to decline vs. the U.S. dollar in 2016," Hugh Johnston, chief financial officer at PepsiCo Inc., said in an earnings call Thursday.

The cost of borrowing in the credit markets has also gone up.

Bonds issued by companies with bottom-of-the-barrel triple-C ratings are trading at yields that are roughly 15.66 percentage points above U.S. Treasurys, compared with 13.51 points at the end of the year, according to Barclays, which maintains closely followed bond indexes.

Spreads on investment-grade triple-B bonds are now at yields that are 2.76 points above Treasurys, compared with 2.2 points at the end of 2015.

Equity financing is getting more expensive, too.

As the S&P 500 Index has fallen 10.5% so far this year, only two companies have gone through with initial public offerings--the lowest number since 2009.

Some market observers have suggested that if conditions get too tight, the Fed will need to back off its path of ratcheting up its policy rate, move in the opposite direction or even consider cutting its own key rates below zero.

"I don't know that markets really start changing their tone until the Fed convincingly walks back from the idea of further tightening or even a reversal," said Sam Garza, a portfolio manager at DoubleLine Capital, which manages $85 billion.

Markets have moved against central banks outside the U.S., too. In the past month, the euro and yen have each risen nearly 5% against the dollar, when the European Central Bank and Bank of Japan would prefer them to weaken.

Mike Cherney contributed to this article.

 

(END) Dow Jones Newswires

February 11, 2016 19:25 ET (00:25 GMT)

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