Lesson 11: How To Predict FED Interest Rate Moves

How To Predict FED Interest Rate Moves

November 26th, 2011 by

the federal reserveThe Federal Reserve system is made up of:

The Board of Governors

7 Members, each appointed by the President and then must be confirmed by the Senate.  In order to avoid political influence, Governors are appointed to serve 14 year terms.

Out of the 7 board members chosen by the president and confirmed by the senate, 1 Governor is appointed to act as Chairman and 1 Governor to Act as Vice Chairman.  The Chairman and the Vice Chairman are elected to serve 4 year terms.

The Chairman of the board of governors is also known as the Federal Reserve Head (or Chief) because he presides over the meetings of the board, and serves as the public spokesperson for the Fed.  The current chairman of the Fed is Ben Bernanke.

Federal Reserve Banks

There are 12 Federal Reserve Banks located throughout the country whose primary responsibilities are:

1. The supervision and auditing of banks in their district
2. The Gathering of Economic Data for their districts (which is used to determine monetary policy, among other things).
3. The Issue and Redemption of Savings and Treasury Bonds
4. Banking services such as the issue of currency and coin, check processing, and wire transfers.

The Federal Open Market Committee (FOMC)

The Federal Open Market Committee  is responsible for setting monetary policy and is therefore what market participants including fixed income investors focus on.  The FOMC has 12 members, which include all 7 members of the board of governors and 5 Federal Reserve Bank presidents.  The board of governors as well as the head of the Federal Reserve Bank of NY have permanent seats on the committee.  The other 4 seats are filled on a rotating basis by 4 of the 12 heads of the federal reserve district banks.

What Investors Need to Watch For

Generally speaking we know what the FOMC is thinking, because they give us a summary of their thoughts a brief monetary policy statement which is released directly after each FOMC meeting.  They also release the actual transcript of the meeting 3 weeks later, so we know what they are thinking on a very detailed level.

What the market really tries to do is anticipate changes in monetary policy ahead of time, by focusing on things that could change the Fed’s outlook on the economy, and cause them to react with a change in monetary policy.

So what can change?

The underlying economic data.

The Fed pays close attention to economic data. As their monetary policy tools tend to take a significant amount of time to impact the economy, they are trying to analyze not only the current situation, but forecast what will happen in six months. The market is always trying to see the economic trends before the Fed does, and therefore be able to predict what the Fed will do in advance.

In terms of Fed decision making, the market is not interested in the state of the economy, but rather unexpected changes in the state of the economy. If the Fed thinks the important economic data is going to be moderately bad, and it is moderately bad, there is not likely going to be a change in monetary policy.

The Fed’s current publicly shared thinking about the economy (good or bad) is “baked into” market prices and therefor the market focuses on what could change their thinking.

Fed Speeches

In addition to looking at the economic data to try and anticipate changes in monetary policy, investors will also watch speeches given by members of the FOMC in between meetings.  In order to avoid making a change that would surprise the market and therefore cause unnecessary volatility, the Fed will normally signal changes in their thinking ahead of FOMC meetings.   They do this through speeches given in between the meetings which the market also pays a lot of attention to.

Doves, Hawks and Moderates

Not all members of the Fed think alike, so its important to watch their speeches through the lens of their economic views, which fall into three broad categories:

  1. Doves: Fed Members who tend to place a greater emphasis on maintaining economic growth than keeping inflation low are called Doves.
  2. Moderates: Fed members who are seen as giving equal weight to economic growth and price stability are called moderates.
  3. Hawks: Members of the fed who tend to place a greater emphasis on price stability than on economic growth are called Hawks.

This is important to understand because a statement in a speech made by a hawk about inflation is going to be given much less weight by the market than the same statement made by a Dove.

For a list of current Fed members and whether they are considered a Dove, Moderate, or Hawk go here.

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