Moving Markets Without Moving Interest Rates

Financial market observers and participants have been abuzz the past few days in anticipation of the release of the latest Federal Reserve Board interest rate statement tomorrow afternoon. The statement is expected around 2.15 p.m., and will be the result of two days of discussion about the state of the economy among Board members.

Though nobody anticipates the Fed to actually change its target for the federal funds rate during this meeting, it can still release a statement that has a high impact on the financial markets. Though not something a casual observer might be aware of, markets anticipate actual rate moves as they are discussed, analyzed and typically signalled far in advance of Fed moves. Therefore, interest rate changes are often priced into interest rates and equity markets ahead of changes. However, when rates have stayed at a certain level, such as the currently low range of 0.00% to 0.25%, for an extended period, the wording of statements can have a far greater impact on investor behavior than actual rate changes.

The key language utilized in the past few statements has been '...exceptionally low levels of the federal funds rate for an extended period.' This indicates that, due to economic conditions, the Fed is willing to keep interest rates low to stimulate borrowing, and in effect, spending, by consumers and corporations. However, some economic numbers have been improving recently while the dollar has been dropping due to low rates. If the Fed were to do something as seemingly small as drop the 'extended period' from the end of its statement, than it would be a strong signal to the markets that the Fed, which has the latest and greatest information on the economy, sees conditions improving. Though this might cause a drop in the stock market immediately as it would mean less lending liquidity in the future, it would also likely strengthen the dollar in the short-term. This is because the demand for dollar-denominated securities will increase. It will also be a good signal for equities in the short- to medium-terms because earnings should improve as the overall economy does.

Though there are reports that the Board members are sharply divided on whether or not to change the language, the statement as released  is typically seen as representing the voice of the whole board. Therefore, whatever is released will be a strong signal to the markets about the direction the Fed believes the economy is moving, and in effect, the direction it may take after the turn of the year.