Watch the Dollar, Not Rates, as Fed Meets

A Federal Reserve rate increase could do more to strengthen the greenback than raise Treasury yields

By Justin Lahart

     The Federal Reserve is considered unlikely to tighten policy this week, but it may signal a rate increase could happen as soon as September. Photo: Zuma Press


The Federal Reserve is laying the groundwork to raise rates again. The dollar, rather than bonds, will likely bear the brunt of the increase.

While there is little chance the Fed will tighten policy this week, it will likely use the meeting as an opportunity to signal that its next move on rates could happen as early as September. A series of stronger-than-expected economic reports has allayed fears that the economy was slowing, and with the stock market hitting new highs, worries about Brexit’s effects on the U.S. economy have faded.

But rather than push Treasury yields higher, a hawkish turn from the Fed might instead strengthen the dollar—a repeat of what happened in the run-up to last December’s rate increase.

Increasingly, it seems like the old playbook, in which the Fed raises short-term rates and long-term rates follow, doesn’t work like it used to. It is a playbook that treats the economy as closed—one where international trade and global financial markets have only a negligible effect. For big economies like the U.S., such closed-economy models have been a useful framework.

But the U.S. isn’t as closed as it used to be, and that is making the Fed’s job harder. Trade, as measured by combined exports and imports, was 28% of gross domestic product in 2015, up from 20% in 1990.

America’s exposure to global financial markets is much higher. Foreign-exchange trading in the dollar has nearly quintupled since 1995. The Fed got its first real taste of the downside to this exposure in the mid-2000s, when heavy demand from emerging-market investors pushed Treasury yields lower even as it raised rates.

With the world’s central banks easing policy, an open-economy model, traditionally applied to smaller, trade-exposed countries like the Netherlands, may be the better framework. In it, interest rates are set by the world rather than the central bank. Capital flows to countries with higher rates, pushing those rates lower.

Higher demand for those higher yielding bonds pushes the currency higher. This slows the economy, but it slows it in a different way than higher long-term interest rates do. Rather than raising borrowing costs, it hurts domestic businesses by making their exports more expensive and imported goods cheaper.

The statistician George Box was fond of saying that all models are wrong, but some are useful.

For now, the open-economy model may be the useful one for U.S. investors.

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