Trying to figure out what the Federal Reserve (the Fed) is saying may be difficult at times, but it's important because the Fed has a significant impact on our overall economy as well as on market prices. When someone in a position of influence at the Fed, especially the very powerful chairman, says something, it's analyzed very carefully to see if there is any indication of its future actions. It's important to understand and pay attention to what members of the Fed are saying - but what are they saying, and what does it mean? Read on for tips on how to translate "Fed speak" into plain English.
Why Listen to the Fed?
The economy presents a systematic risk to any investor's portfolio that can't be removed through diversification; therefore, many investors care a great deal about the overall economy. The Fed arguably has more direct and meaningful impact on the economy than any other single entity.
The Fed is the central bank of the United States and has authority to conduct monetary policy, which is far more powerful in influencing the economy than fiscal policy, which is under the control of Congress and the president. This is why the markets rarely move in response to anything the president, his politically appointed Treasury secretary, or Congress has to say. This authority to conduct monetary policy gives the Fed significant power to expand or contract the money supply as it sees fit.
When the Fed indicates that there will be an expansion in monetary policy, it is a positive sign for stock prices in the future, and a buy signal for many traders, because a growing economy will increase revenues and the value of publicly-traded companies. If the Fed indicates a contraction in the monetary policy, which means it is trying to get the economy to slow down, it is a negative sign for future equity prices, as business growth will likely slow in the near term.
Does Every Word Matter?
The Fed communicates through speeches, press releases and testimony to Congress. Each event is analyzed as to any indication of a change in policy. Even the smallest change in a phrase, including a single word, can impact the markets.
At one point, the media went so far as to report on the thickness of the briefcase that former Fed chairman Alan Greenspan carried to the all-important Federal Open Market Committee (FOMC) meeting. If it was thin, it was suspected that there wouldn't be a change in policy, because not enough evidence was being taken into the meeting. If it was thick, the larger package of (presumably) economic data could be an indication of a forthcoming change. Although its accuracy is questionable, the so called "briefcase indicator" shows the intensity of interest in the Fed's meetings.
One area of great interest is the statement released after every FOMC meeting. At precisely 2 p.m. EST on the last day of the meeting, the media and analysts are ready to not only look for actual changes in policy and interest rates, but also to compare the statement word for word with previous statements and make note of any changes at all. Even a small change in tone can have an impact, as markets often move on expectations of future events more than the actual events themselves.
Also in this statement is a summary of which committee members voted for and against the current policy. This is seen as another indication of the Fed's future actions and it's something the markets will pay attention to. A unanimous vote is a sign that the Fed plans to stay with its policy for some time, but as dissenters increase in number, a policy shift may be in the making.
All statements by Fed officials get some attention; if there is any indication of a change in policy, the media makes it into a story and the markets tend to move on it. So, while the Fed officials speak in public quite often, they very carefully avoid conveying an unintended message.
Why Don't They Speak Plain English?
When the Fed doesn't want to send a message, it often says a whole lot of nothing. Alan Greenspan was so good at using language that was confusing and meaningless, the term "Fed speak" was coined to refer to his vague statements. In his book, "The Age of Turbulence," Greenspan revealed that this method of avoiding the issues directly when a clear message wasn't desired was not unintentional. The confusion was used to prevent unintended jolts to the markets as confusing statements are typically just ignored.
Many of Greenspan's murkiest messages centered on the semiannual testimony he gave to Congress. On these occasions, the members of the House Financial Services Committee or the Senate Committee on Banking, Housing, and Urban Affairs are allowed to ask the chairman of the Federal Reserve questions directly. As politicians, they often try to get the chairman to voice an opinion in favor of a policy they preferred. To avoid providing a direct answer, Greenspan was known to provide an answer that neither they, nor anyone else, could easily understand. In other words, he wouldn't give politicians a sound bite that they could use to promote their issue unless he wanted to, which he rarely did.
Differences Between Bernanke and Greenspan
One of the issues in choosing Ben Bernanke to replace the term-limited Alan Greenspan, who retired in 2006, was his reputation for providing clear answers and statements. In February 2006, The Wall Street Journal reported the stark contrast in the responses each man gave when asked about an inverted yield curve as a predictor of a future recession. Chairman Greenspan said, "History suggests that is usually or has been a forward indicator for softening economic activity ... I suspect, however, that we have changed the structure of the flow of funds and the relationships among the various interest-rate tranches by maturity such that I'm not sure what such a configuration ... would mean." They contrasted Greenspan's response to the one given by Chairman Bernanke response when posed the same question a year later: "The inverted yield curve is not signaling a slowdown." However, obscurity may have helped his reputation as Bernanke's answer to the aforementioned question ended up being incorrect a couple years later, as the market saw a massive downturn in 2008.
What to Listen For
Because the Fed's most confusing messages aren't intended to communicate anything of importance, they can be ignored by almost everyone. Only active traders in Fed funds futures, or other directly related securities, will need to concern themselves with the minor nuances of each word so that they can try to profit from what the Fed will do next.
In fact, what matters to most investors are the policy changes themselves. These are clear. The Fed either raises or lowers the Fed funds rate, which is its primary method of expanding or contracting the economy. They usually move in small increments many times, as opposed to large changes over a short period of time, and typically have a period of time where rates stay unchanged, after which they may continue or reverse directions. This actual policy implementation is what sets the intended direction of the economy, and so it's the thing most everyone should be listening for.
What Does This Mean to an Investor or Trader?
For a long-term investor who is holding assets through multiple economic cycles, much of this can be ignored. The Fed is trying to moderate the volatility of the economic cycles by keeping the economy from growing too fast and creating undesired inflation, or too growing too slowly and falling into recession. If the strategy is to buy and hold for long periods of time, short- to moderate-term fluctuations are less of a concern.
From the point of view of a trader - those trying to make money through short- to medium-term buying and selling - the Fed is a factor that shouldn't be ignored, due to its impact on the overall economic outlook and market prices.
For example, if a trader is long equities and the Fed indicates that it's going to tighten monetary policy and slow the economy, it is likely that many companies' sales and profits will moderate in the future. Therefore, it would be wise to be cautious and review portfolio holdings closely.
On the other hand, given the same long equity position, if the Fed indicated that it was loosening monetary policy, this would increase the likelihood of higher company profits and, therefore, higher stock prices.
The Bottom Line
Many traders look at Fed policy as setting the future direction of the overall economy and, therefore, the direction of the markets in general. This led to the saying, "Don't fight the Fed." Although many other factors can play a role in the movement of stock prices, the reason that so many people listen to the Fed is clear - its policies have a significant impact on the economy and, therefore, the markets.