How Federal Open Market Committee Meetings Drive Rates And Stocks

By Amy Fontinelle | September 02, 2014 AAA

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.

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