Lesson 61 – How the Fed Signals Policy Changes Beforehand

Topic Progress:

In our last lesson we looked at how The Fed is expected to react at different points in the business cycle, and what the expected market movement will be as a result. In today’s lesson we are going to look at how the Fed goes about signaling to the market changes in their thinking on the direction of monetary policy, so we can begin to understand why markets react not only to Fed interest rate announcements but just as importantly to events which change the markets anticipation of how the Fed may react.

While we have simplified the situation in order to better understand the basics of how The Fed uses monetary policy, as you can probably tell by now, forecasting economic conditions and using monetary policy to try and manage those conditions is a very difficult process. The members of the FOMC are constantly analyzing economic data from across the country to try and gauge where the economy is in the business cycle and what if any monetary policy action is needed.

As we have touched on in previous lessons, the FOMC has 8 regularly scheduled meetings throughout the year where they meet to discuss current economic conditions and expectations of future conditions. It is at these meetings that decisions on what changes if any in monetary policy need to be made.

As we’ve learned in previous lessons as well, what the FOMC decides to do with their target for Fed Funds Rate at this meeting has wide ramifications for the economy and therefore the markets. With this in mind the results of these meetings are closely followed by market participants. It is important to understand however that the market not only looks for whether or not the FOMC takes action on the Fed Funds Rate and by how much, but also for any clues in the Fed’s Statement as to what their bias may be for future rate decisions.

This is a very key point to understand because the markets are always trying to anticipate what is going to happen and therefore they move up and down depending on what people think will happen to rates going forward. Anything that comes out from this meeting or any thing else that is in line with what the market expects should have little or no effect on the market. Conversely anything that comes out which changes the markets forecasts on what if any Fed action will be, can cause drastic moves in the markets as participants react to this new information and markets adjust accordingly.

The large market volatility that can be caused when market participants are caught off guard by a change or lack thereof in the Fed Funds Rate is not a desirable outcome for anyone in the markets including the Federal Reserve. In order to try and prevent the large moves which occur when the market is caught off guard the Fed will always try to signal ahead of time what their stance is on interest rates, and more times than not by the time the FOMC decision is released, the market has already priced in whatever action if any is taken on the Fed Funds rate. The three main ways the Fed will signal its intentions to the market are:

  1. The release of the policy decision after the FOMC Meeting. Again here while the announcement of what if any change in the Fed Funds Rate target will be made is obviously an important component of the release, just as and many times even more important is the accompanying statement which normally includes the Fed’s “bias” going forward.

By reviewing the statement from the most recent FOMC meeting, you can see that the bias going forward is for the Fed to reduce interest rates. Although they say that “inflation needs to be monitored” they also say that they “expect it to moderate”. They also come right out and say that “downside risks to growth remain” and that they will “act as needed to address those risks”

  1. The FOMC Meeting Minutes. The notes or minutes from the latest FOMC Meeting are released 3 weeks after the meeting. These are a much more detailed account of what was discussed at the most recent FOMC meeting and market participants will pour over this release as well looking for clues as to future policy action.
  1. Public Speeches: Voting members of the FOMC will give speeches periodically where they will discuss recent economic events and sometimes signal potential changes in their bias. These speeches, especially ones made by the chairman of the fed who is its main voice, will also be closely monitored by market participants as well.

Lastly, market participants will also closely monitor economic releases for any signals that the economy may be growing more or less than the market is currently expecting. There are a few economic releases that are the most important in this regard which will be the topic of our next lesson.