Inside the Fed’s Revised Policy Playbook

The U.S. Federal Reserve altered its approach to managing economic risk. Here’s what it means for investors.

In Brief

• With a dramatic shift in expectations for interest-rate moves from the U.S. Federal Reserve (Fed), we think it’s time to take a fresh look at some recent changes in how it frames its policy choices.
• In our view, today’s Fed is more willing to venture fine-tuning its policy stance despite no tangible signs of serious recession risk.
• Also, in an effort to get ahead of changing conditions, Fed officials appear to be more forcefully targeting data expectations and market-implied measures of future economic outcomes.
• Finally, policymakers seem to be giving greater weight to developments in overseas economies and their potential influence on U.S. growth.

Market expectations for U.S. Federal Reserve (Fed) policy have shifted dramatically in recent months. Based on fed funds futures data compiled by Bloomberg, investors believe the Fed is poised to cut the U.S. benchmark interest rate by 75 basis points (bps) in the next 12 months, a dramatic reversal from prior expectations of Fed hikes. This shift, combined with several other traditional indicators of potential U.S. recession, has drawn a significant amount of attention to the possibility of a U.S. economic downturn in the near future. However, equity and credit market valuations are sending a different signal: while risks of a recession ticked up slightly in recent months, the overall likelihood that U.S. growth rates will turn negative remains quite low.

How can investors reconcile such a dramatic shift in Fed policy with a benign economic backdrop? While we are reluctant to once again invoke the idea that “this time is different,” there are indeed several key differences between today—especially the current rate environment and the way the Fed responds to economic developments—and conditions in previous times that can help to explain the apparent divergence in what markets are telling us.

Fed Policy: A Big Change in Rate Expectations
As recently as December 2018, futures data showed that markets were pricing in three additional increases of 25 basis points (bps) each in the fed funds rate in the following 12 months. As previously mentioned, by July 2019, that expectation had reversed markedly. Driven largely by this reversal, the three-month/10-year U.S. Treasury yield curve became inverted, a condition that many observers associate with imminent recession.

Chart 1. The Yield Curve’s Latest Excursion into Inversion
Yield curve differential of the 10-year U.S. Treasury note and the three-month U.S. Treasury note, June 30, 1961–June 30, 2019

Source: Bloomberg. Data as of 06/30/2019.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

Moreover, evidence of a slowdown in global economic growth, combined with signs of decelerating job creation in the United States and a downturn in U.S. manufacturing data gave alarmists ammunition to suggest that this record-long economic expansion has run its course. The underperformance of some cyclical data gives partial credence to these worries, but many other indicators of financial health suggest that this expansion will extend its streak for a while longer. For example, the U.S. unemployment rate remains resolutely low, and financial conditions, as measured by the Chicago Fed National Financial Conditions Index, remain exceptionally accommodative. Meanwhile some of the more rate-sensitive parts of the economy, such as housing, are already showing a positive response to the decline in interest rates precipitated by the shift in Fed expectations.

Fed Shifting its Focus
Why such a divergence? Since the reshaping of the yield curve has corresponded with the re-pricing of Fed expectations, it makes sense to better understand why this current environment, and this particular Fed regime, is so different from prior environments that have given us some of our historical context.

Any discussion of differences between the current economic and market situation from historical precedent must begin with the Fed and the unconventional post-financial crisis policy that has been a major factor in today’s markets. To begin with, the traditional notion of Fed behavior in an economic cycle is that during downturns, the central bank will push overnight rates for banks lower in order to spur lending that might not otherwise occur. In other words, it creates accommodative monetary conditions when the cyclical aspects of the downturn—rising defaults and decreased borrowing—would contract that supply.

What about times when the U.S. economy appears to be running “hot”? Amid highly accommodative borrowing conditions, robust growth rates, and tight labor markets, the economy doesn’t need any help in the form of easy money from the Fed. Rather, money has become too easy, creating inflationary pressures along with rising leverage. The Fed will then move rates above the perceived “neutral” rate¹ to attempt to tighten the supply of money and apply some judicious brakes to unsustainable rates of economic activity.

Today, multiple aspects of this traditional relationship between Fed policy, economic activity, and the money supply are quite different. New factors, such as historically low interest rates, quantitative easing from multiple central banks, and a rate of post-recession recovery that has been historically slow, have influenced market valuations. As discussed elsewhere, these factors rendered the significance of a yield curve inversion as a recession signal—already an imperfect predictor of downturns—even less reliable than usual.

Three Features of a Changing Fed
Amid these currents, how has the Fed’s response to changing economic conditions evolved? We think it’s useful to examine how the Fed’s reaction function² to economic developments has shifted over the past decade, especially with regard to how it deploys rate cuts in response to concerns other than clear-cut signs that growth is slowing or turning negative. We have identified four important considerations:

1. The Fed’s “Risk Management”
With interest rates in most developed economies hovering at or near historic lows, and with significant central bank balance sheet expansions already in place from “quantitative easing” measures, there are fewer policy tools available to central banks to respond to a recession. One school of thought argues that central banks must provide stronger, and earlier, policy responses in order to reduce the risk of slipping back towards zero or negative rates.

How has this affected U.S. policy? The Fed now uses the term “risk management” to explain aggressive early easing in this low neutral rate environment due to limits on conventional policy tools. Because rates are so low, the Fed has less room to cut aggressively before hitting the “zero bound,” so it believes it should be proactive in forestalling economic contraction. Although the Fed always watches economic data releases, the degree of shortfall between incoming data and Fed projections is now the main manifestation of increasing risks to the Fed’s baseline economic assessment. Not coincidentally, recent comments and projections by Fed officials suggest they are now more forcefully targeting data expectations rather than data realizations. This is a more extreme form of “data dependency” or forecast targeting.

Given its desire to target a higher level of inflation than markets currently anticipate, its playbook of being more proactive than reactive, and both slower international growth and the potential risks of further slowdown from trade developments, the Fed apparently believes policy should be accommodative and not restrictive at this time. The shift downward in the neutral rate means that, all else equal, the fed funds rate needs to be lower in order for monetary policy to be accommodative and not restrictive. That is, the Fed needs to cut in order to achieve desired policy goals, not solely because it believes a recession is coming.

2. The Importance of Market-Based Measures of Expectations
While it is difficult to interpret the prices of market instruments due to the various risk and liquidity premia they embed, it seems Fed vice chair Richard Clarida weights them heavily. Taking this approach, an inverted yield curve is a signal that monetary policy is too tight—that is, the market apparently believes the long-term fed funds rate will be below the current rate. Market-based inflation expectations, as seen through TIPS breakevens or CPI swaps, provide a corroborating signal that long-term inflation is expected to be below the Fed’s inflation target.

3.  An Increased Emphasis on Global Developments
Much attention has been given to trade negotiations with China, Mexico, and other trade partners, along with serious concerns over the implications of a trade war. The focus on these developments highlights the growing importance of trade to economies worldwide. Where the Fed once focused solely on its dual mandate of full employment and price stability in the United States, it has increasingly acknowledged the increasing relevance of international economic trends, as well as dollar supply and currency issues, to the formation of policy.

Over the past five years, the role of U.S. dollar supply and international growth has become a central topic of Fed policy discussion. The complex web of dollar funding is also a frequent topic at the Federal Reserve Bank of New York. Clarida recently noted in a policy speech that, when the global economy slows, it impacts the U.S. through exports and financial conditions.³ We interpret this as hinting that the Fed seems more willing to take action based on financial conditions outside of the United States. As a result, potential Fed cuts right now may say far more about international developments than about any recessionary risk at home.

Summing Up: Fed Expectations and Potential Investment Opportunities
Slowing growth and a newfound lower level of the neutral rate are good reasons to take a fresh look at monetary policy. We do not view the United States as being in a recession, so any Fed moves right now may be considered “fine-tuning” its policy stance. One potential drawback of this approach is that markets increase their perception of policy volatility, which could then spill over into general rate volatility. In order to reduce that uncertainty, the Federal Reserve must clearly describe the framework for its outlook. One way to do that would be a single forecast and “inflation report”—the kind that other central banks already produce. We believe a unified baseline forecast would go a long way to helping market participants understand the Fed’s reaction function in a time when it operates on a largely holistic menu of incoming data to assess the balance of risks.

In the meantime, investors focused on market-based measures likely will continue their tendency to over-predict Fed actions, and thus mistime hiking and cutting cycles, even as the central bank has endeavored to improve policy communication and manage market expectations. Thus, we may see some volatility in asset prices as market participants assess, and reassess, the number of potential Fed cuts over the next several months. Such episodes may provide attractive opportunities for patient, long-term investors, given the overall backdrop of solid U.S. economic fundamentals, low inflation, and a resolutely accommodative Fed.

¹The neutral rate of interest is the theoretical interest rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive.
²The reaction function refers to how the U.S. Federal Reserve alters monetary policy in response to economic developments.

³Richard H. Clarida, “The Federal Reserve's Review of Its Monetary Policy Strategy, Tools, and Communication Practices,” July 1, 2019.