The Fed Was Waiting on Data. It Found a New Mind-Set Instead.

(Bloomberg Opinion) -- The Fed may be hoping that a deeper and faster cut to interest rates will support economic growth, but its biggest impact may be on the dollar.

Despite some hesitance on the part of Federal Reserve regional bank presidents recently about the wisdom of interest rate cuts later this month, and U.S. economic data that has been better this month, markets are increasingly of the view that the Fed will cut its target rate by 0.5% at its July meeting – not moving by quarter-point increments, and not waiting later in the year.

This evolving Fed approach has happened quickly, with the central bank as recently as December staying on the course of increasing interest rates with the goal of getting rates to a "neutral" level. Several events unfolded since then to shake officials off that course.

The stock market selloff toward the end of the year, with financial conditions tightening somewhat, spooked market observers. While U.S. economic growth has been steady this year, global data has been softer, with concerns that there could be impacts domestically. Increased trade tensions hurt

business confidence, and longer-dated Treasury yields dropped significantly in response to the weak global data and sagging business confidence. That drop inverted some parts of the Treasury yield curve, with the three-month yield higher than yields on longer-dated securities.

What's a little awkward for the Fed is that officials said the reason they didn't cut interest rates in June was that they wanted to see more data before making any decisions. And yet even as the real-time data has improved since the June meeting, the Fed appears to be moving in a more dovish direction. It’s a reasonable shift, but it does not match the reasons they've articulated.

A couple things seem to be spooking the Fed, factors that seem to be dictating the direction of policy more than the real-time economic data at the moment. The first is the yield curve. Last summer, Atlanta Fed President Raphael Bostic pledged not to take any action that would "knowingly invert the yield curve." By cutting rates now, particularly when inflation isn't running above the target, the Fed can restore the yield curve, an insurance measure with seemingly little cost at the moment.

The second, as New York Fed President John Williams and Fed Governor Richard Clarida said in speeches on Thursday, is that research shows, particularly when interest rates are near the zero lower bound, that you're better off acting preemptively while you can in the face of downside risks, rather than waiting for those risks to show up in the actual economic data.

This might mean a new late-cycle policy regime for the Fed. The phrase that's been preached for the past several years is that the Fed is "data dependent," and to some extent that will remain the case. But now the philosophy might be "don't let the yield curve invert, and if it inverts, cut rates to fix it." Additionally, in the face of uncertainty and downside risks, you're better off cutting rates first and asking questions later. If somehow inflation does get hotter than the Fed wants, go back to the standard Fed playbook.

It's debatable how much of an impact this will have on the real economy in the U.S. This has not been a particularly credit-sensitive economic expansion, with households still generally risk averse after the shock of the financial crisis. Much of the rise in debt in the corporate sector has been used to fund stock buybacks. There may be some trickle down effects if market psychology improves from lower rates, but it's not clear whether the tweaking of monetary policy at the margins matters much for the U.S. economy right now.

Where this new, more preemptive approach is likely to matter is in the foreign exchange markets. Every time the Fed has said or done something dovish over the past couple months, the immediate impact has been the dollar selling off. The same thing occurred on Thursday in response to remarks made by Williams and Clarida. Gold made a new 52-week high.

Weakening the dollar is something that is increasingly gaining bipartisan support, with both President Donald Trump and Senator Elizabeth Warren supporting it. While the Fed has said it's not trying to weaken the dollar, the Fed's evolving approach seems likely to suppress the dollar and give leaders of both parties what they want.

To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

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