Ask Emily - Why do the markets react so much when the Fed takes no action?

During the last several FOMC meetings, the Fed has decided to leave the federal funds rate at 1%, thereby sparking waves of activity. Why do the markets react so much when the Fed takes no action? Despite Fed votes to take no action, markets react to the verbiage or tag lines that come with the announcement. Ordinarily, Fed movement is somewhat predictable. What the markets are waiting to know, however, is the future action of the Fed, or what rate biases the Fed might have.

 

By Trust for Credit Unions Mutual Funds

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During the last several FOMC meetings, the Fed has decided to leave the federal funds rate at 1%, thereby sparking waves of activity. Why do the markets react so much when the Fed takes no action?

Despite Fed votes to take "no action", markets react to the verbiage or "tag lines" that come with the announcement. Ordinarily, Fed movement is somewhat predictable. What the markets are waiting to know, however, is the future action of the Fed, or what rate biases the Fed might have.

The Fed has to be very careful in the way that it communicates to the public for fear of market overreactions. Remember the infamous "irrational exuberance" term used by Chairman Greenspan in 1999? Recently, the Fed has been adding and subtracting code words at every meeting. On February 3, 2004, when the Fed replaced the words "considerable period" to "patience" in its Fed policy statement, this seemingly minor change caused quite a market rally (yields fell). What exactly does "patient" mean? "Patient" does not mean forever, neither does it mean "six months'. It means that the Fed will have to see certain signs of economic recovery before it reacts. Remember, six months is "long term" for most bond traders whose average holding period of a 30-year bond is less than 30 days!

Recently, new terms such as "unwelcome inflation" and "potential growth" have been introduced to the lexicon. What exact level is "unwelcome" and what is the actual "potential growth" rate? Even Chairman Greenspan recognizes the elusiveness of the Fed's language, for example, when he said to a Congressional Committee, "If you understood what I just said, then you must not have heard me correctly".

On March 16, 2004, the 12 voting members of the Fed voted unanimously to leave the federal funds rate unchanged at 1%. Although the Fed repeated its vow to be "patient" about rising interest rates, it announced that recent evidence "indicates" economic activity is expanding at a "solid pace". The markets concluded from these remarks that the Fed had become slightly less upbeat than the previous meeting's announcement in which economic evidence "confirmed" activity was growing "briskly". The result was yet another bond rally.

For economists and analysts alike, it has never been more important to have a thesaurus and dictionary at hand in an attempt to understand the Fed's true meaning. Because, as everyone knows, once it commences moving rates, one small step for the Fed, can be one giant leap for the bond market.

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March 29, 2004


Comments

 
 
 
  • Anticipatory "grief".
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  • Interesting and Fun!
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