The Federal Reserve Board can be cautious in its approach to raising interest rates even as financial markets appear to be slow in responding to the shift in policy, according to a new report from National Bank Financial.

In the report NBF says that the response of financial markets to imminent Fed tightening has been different from that of the comparable tightening cycle in 1994. “Market rates have lagged the acceleration of inflation, making corporate real rates more accommodative than in 1994,” it points out.

NBF bases this conclusion on the behaviour of its proprietary index of financial conditions, which considers corporate short rates on commercial paper, corporate long rates on bonds, broad equity markets and a real trade-weighted exchange rate.

NBF says that the Fed’s conventional tool of monetary policy, the federal funds rate, is a fragmentary indicator of financial conditions in that it does not provide information about other factors that stimulate or brake the economy. And, its proprietary index of financial conditions incorporates a broader range of capital-market conditions. “The transmission lags and desirable amplitude of a tightening depend on the reaction of the financial markets, which do not always respond in the same way to shifts in monetary policy,” the report says.

Still, despite the apparent lags that NBF observes in its index, the report says that the Fed is unlikely to tighten harder to offset this behaviour. “Though the financial markets are, in real terms, behind the curve of their 1994 reactions, the Fed in our view has room to move judiciously. It may lift its foot from the accelerator but it will not necessarily hit the brakes,” it predicts.

“U.S. households are carrying a heavy debt load, the economy is not yet operating at capacity, inflation is low and the effect of tax cuts will fade next year. The Fed need not be aggressive,” the report says. “We expect it to tighten more gradually than in 1994.”