The Federal Reserve is preparing to deliver what the market expects to be the first of multiple interest-rate cuts. The others are sure to follow if policy makers can’t break what’s starting to look like a vicious circle.

The Fed isn’t simply bending to the market’s will with this cut: It highlighted the risks of weak inflation and global trade hostilities to explain a series of dovish pivots this year. But the shift started in the teeth of a market uproar, and a big worry is that traders will keep wanting more. As futures traders have boosted bets on easing, a rate cut has gone from an outlier call among economists to a certainty.

While markets have always been an input in Fed policy, concerns are growing that a feedback loop between the two could be creating distortions that will lead to asset bubbles.

“The approach today is one that is quite sensitive to market conditions -- for better or for worse,” said Stephen Stanley, the chief economist at Amherst Pierpont Securities in New York. In January he expected three rate hikes this year, but has since changed his forecast to one quarter-point cut.

If it indeed eases in July, the Fed will be looking past decent domestic growth and the lowest jobless rate in a half-century. Many investors have expressed surprise that in just seven months the majority on the Fed could have switched from supporting at least three more hikes, to a cut. A Fed that abandons its rate projections and other policy normalization plans following December’s serious brush with volatility in stocks may leave investors wondering how far it will bend to the market’s will, and at what cost.

There’s nothing wrong with policy makers factoring financial conditions into their thinking, since, for instance, stocks are a guide to investors’ views about the future, and the dollar and rates reflect ease of funding. The potential trap is when conditions are easy only because markets are expecting a cut, and could reverse quickly if they’re disappointed.

Questions lurk. Should stocks begin to dip after the rate cut that everyone expects this month, or financial conditions tighten, will the Fed move to ease conditions further? And if not, does that mean markets could be due for a sudden sell-off when investors realize the Fed is actually just as attuned to economic data as it has always been?

Investors struggled with the Fed’s thinking in particular Thursday, piling up bets on a larger cut this month after Vice Chairman Richard Clarida told Fox Business Network, “You don’t need to wait until things get so bad to have a dramatic series of rate cuts.” This followed the New York branch’s president, John Williams, saying that “when you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress.”

Those wagers receded after a spokeswoman for the bank said Williams’ comments didn’t relate to this month’s meeting.

Sowing Seeds
Expanding corporate leverage and the shrinking yield premium on riskier debt is starting to ring alarm bells for Lisa Hornby, a fixed-income money manager at Schroders.

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