Janet Yellen was sworn in as Federal Reserve chair on Feb. 3, 2014. On March 18 and 19, she led her first Federal Open Market Committee (FOMC) meeting. The meetings are about changes in Fed policy, based on the latest economic data, and are followed by public announcements that are important for investors and consumers. You can think of these meetings as the government equivalent of a quarterly earnings report, only with much higher stakes. These announcements have an immediate effect on interest rates, stock market returns and bond yields. And just as with corporations’ quarterly earnings reports, investors try to predict what the FOMC will announce beforehand. If the announcement matches expectations, the stock and bond markets will have little reaction, but if it doesn’t, the markets can shift significantly. 

Why You Should Care

Though many people not involved in finance might be tempted to disregard anything Yellen or FOMC has to say, the outcome of these meetings have real consequences for ordinary citizens. As Yellen said in a speech she delivered in Chicago on March 31, "Although [the Fed] work[s] through financial markets, our goal is to help Main Street, not Wall Street. By keeping interest rates low, we are trying to make homes more affordable and revive the housing market. We are trying to make it cheaper for businesses to build, expand, and hire." 

What Does the FOMC Do?

The FOMC meets eight times a year, approximately every six weeks. Its 12 members include the Board of Governors, a seven-member group that votes on Fed policy, along with the president of the Federal Reserve Bank of New York and four other regional Federal Reserve bank presidents. These meeting announcements constitute part of the Fed’s forward guidance, a policy of clearly informing the public of what actions the Fed intends to take in the future and under what conditions.

One of the FOMC’s two key decisions concerns the Fed funds rate. The Fed has tried to keep this rate at the zero-bound, the lowest possible rate of 0% to 0.25%, since the end of 2008 to promote economic recovery. The FOMC’s other major decision at its meetings is whether to increase or decrease the money supply. Increasing the money supply causes interest rates to fall, while decreasing it causes interest rates to rise. Since 2008, the Fed has been increasing the money supply through quantitative easing, as well as through purchasing agency mortgage-backed securities and longer-term Treasury securities.

In December 2013, however, in response to the economic recovery, the Fed began to slow down these purchases, a process called “tapering.” When tapering began, the Fed was purchasing $85 billion of these securities per month. At each of the three FOMC meetings between December 2013 and March 2014, the Fed decided to reduce purchases gradually, by $10 billion per month.

When Yellen became chair, the two primary goals she wanted to achieve through Fed policy were reducing the unemployment rate from 6.6% to 6.5% or lower, and increasing inflation from 1.5% to 2%. The Fed’s plan for achieving these goals was to keep the Fed funds rate target in the 0% to 0.25% range and to continue tapering quantitative easing - in other words, to continue the policies of Yellen’s predecessor, Ben Bernanke. Analysts expected Fed policy to stay the course with Yellen in charge, and the stock market responded favorably when she took over. Yellen then said that even if unemployment were to fall to 6.5%, the Fed wouldn’t change course until other labor-market indicators and inflation improved.

The FOMC’s March 19 Announcement and Immediate Aftermath

After its March 19 meeting, the FOMC announced that it had decided to continue keeping the Fed funds rate target at 0% to 0.25% - no surprise there. Yellen said the Fed would probably continue to do so for about six months after quantitative easing ends, which means we could see the target Fed funds rate rise as soon as the spring of 2015. Thirteen of the 16 FOMC participants expect the target Fed funds rate to rise in 2015, but they still see that rate ranging between 0% and 2% and not reaching 4% until 2016 or after.

On March 19, after the FOMC’s announcement, the 10-year Treasury yield increased to 2.77% from the previous day’s 2.67%. Two- and five-year Treasuries also rose significantly. Higher Treasury yields mean consumers pay a higher interest rate on auto loans, mortgages and other types of debt. They also mean that investors earn more from federal debt securities and don’t need to turn as heavily toward stocks to earn a better return.

“If the Fed continues to pursue the policy path outlined in the March 19 FOMC press release, we are likely to see interest rates gradually rise as asset purchases draw to a close and Fed policymakers signal rate increases in early or mid-2015,” says Evan A. Schnidman, founder and CEO of Fed Playbook, a financial forecasting and analysis firm that uses quantitative data to forecast Fed policy and market outcomes. “As the Fed signals these rate increases, we could see an interesting distortion in Treasury yields,” he adds. “The result could be temporarily higher short-term yields even as long-term interest rates remain relatively low due to controlled inflation expectations.”

All three major stock indices saw declines after the FOMC’s announcement. Compared to the previous day, the Dow Jones Industrial Average on March 19 fell 0.7%, the Nasdaq Composite Index fell 0.6% and the S&P 500 index fell 0.6%.

“The stock market definitely overreacted to Janet Yellen’s remarks,” Schnidman says. “It is a common practice for new central bankers, including Fed chairs, to portray themselves as hawkish in order to keep long-run inflation expectations down. This was particularly important for Yellen since she already had a dovish reputation. The Fed’s policy is continuing as expected at the pace markets anticipated.”

Investor exuberance and price-to-earnings ratios matter more for stock values than Treasury yields, Schnidman says. “However, it is worth noting that traditional P/E valuations are less credible in a market where the central bank has injected $4 trillion in cash.”

FOMC Longer-Term Goals

The FOMC continues to expect GDP to grow by about 3% in 2014, similar to its previous projection. This piece of information should not affect bond yields. Future predictions for a faster growth rate could increase bond yields and cause the Fed to raise the Fed funds rate to restrain inflation.

Yellen said in February that the course of tapering is not preset, a point that she reiterated March 19, but so far tapering has followed a consistent path. The latest figures put the unemployment rate at 6.7%.

“The unemployment rate is likely to continue its current downward trajectory, but as some workers re-enter the labor market, the pace of unemployment rate drops are likely to decrease,” Schnidman says. “However, recent evidence suggests that a significant portion of the workers who exited the labor market in the last few years are baby boomers retiring,” and this along with other structural factors means “the labor market re-entry rate may be less than was previously anticipated,” he adds. “This could cause the unemployment rate to continue to drop relatively quickly.”

The FOMC generally does not specify a fixed goal for maximum employment; rather, the FOMC's policy decisions must be informed by its members' assessments of the maximum employment level, though such assessments are necessarily uncertain and subject to revision. According to the FOMC's most recent Summary of Economic Projections, "Committee participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 to 5.8%." If the unemployment rate continues to fall, we can expect continued tapering and, eventually, a higher Fed funds rate.

Continued tapering should continue to increase Treasury yields. The Fed must wind down quantitative easing carefully, however, to avoid pushing inflation above the 2% target. It could slow, stop or even reverse tapering if the economy stalls again. With tapering, quantitative easing is still in effect; it’s just occurring at a slower pace than in previous months. Thus, longer-term interest rates should remain low and promote a continued economic recovery.

The Bottom Line

Fed policy makers’ forecasts are likely to change over time as economic conditions evolve, so investors and consumers shouldn’t cling to them. Still, it makes sense to base today’s investment and borrowing decisions on the best information we have now. If you’re likely to move across the country in a year to take a new job, it doesn’t make sense to buy a house now even though analysts think interest rates will rise. If you’re a small business owner, don’t take out a loan that you don’t need just because rates are low. And if you have a lot of cash sitting around that would be better off earning interest in a relatively safe vehicle like bonds, it might make sense to invest at today’s potentially lower rates than to miss out on earning any interest by waiting and hoping for rates to rise.

Related Articles
  1. Mutual Funds & ETFs

    The Top 5 Technology ETFs for 2016 (FDN, IGV)

    Read about five technology-based ETFs that could be poised to take off in 2016, and why no investor can afford to shy away from tech.
  2. Markets

    What Will Happen To Treasury Yields With Yellen And Tapering?

    Janet Yellen was sworn in as Federal Reserve chair Feb. 3, 2014, ending Ben Bernanke's eight-year tenure. Yellen assumes her role at a time when the economy is its strongest since the recession ...
  3. Investing News

    What's the Fed Going to do in 2016?

    Learn about the factors that contribute to increases in the federal funds rate by the Federal Reserve and key economic indicators for 2016.
  4. Economics

    How Interest Rates Affect The U.S. Markets

    When indicators rise more than 3% a year, the Fed raises the federal funds rate to keep inflation under control.
  5. Economics

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  6. Markets

    The (Expected) Market Impact of the 2016 Election

    With primary season upon us, investor attention is beginning to turn to the upcoming U.S. presidential election.
  7. Bonds & Fixed Income

    3 Risks U.S. Bonds Face in 2016

    Learn about the major risks for the bond market in 2016; interest rate increases, high-yield bond volatility and a flatter yield curve may be issues.
  8. Economics

    The Ripple Effect: Interest Rates and the Stock Market

    Investors should observe the Federal Reserve’s funds rate, which is the cost banks pay to borrow from Federal Reserve banks.
  9. Economics

    3 Things That May Happen at FOMC Meeting

    We are keeping a close eye on what the Fed will say about economic outcomes and participants’ viewpoints at the FOMC meeting this week.
  10. Economics

    A Look At Fiscal And Monetary Policy

    Fiscal and monetary policies provide our government and the Federal Reserve with two powerful tools to regulate the economy.
RELATED FAQS
  1. What were the objectives of the Glass-Steagall Act?

    The objectives of the Glass-Steagall Act were “to provide for the safer and more effective use of the assets of banks, to ... Read Full Answer >>
  2. How does the Wall Street Journal prime rate forecast work?

    The prime rate forecast is also known as the consensus prime rate, or the average prime rate defined by the Wall Street Journal ... Read Full Answer >>
  3. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
  4. What happens if interest rates increase too quickly?

    When interest rates increase too quickly, it can cause a chain reaction that affects the domestic economy as well as the ... Read Full Answer >>
  5. When was the last time the Federal Reserve hiked interest rates?

    The last time the U.S. Federal Reserve increased the federal funds rate was in June 2006, when the rate was increased from ... Read Full Answer >>
  6. Do lower interest rates increase investment spending?

    Lower Interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center