For many investors, traders and market watchers, the words of the Federal Reserve or the ‘Fed’, carry significant weight. Even the slightest change in tone from the central bank can have an immediate impact on markets. As such, there is a long-held theory that the Fed uses its language to control markets, often threatening to raise interest rates as a way to guide investor behaviour, without following through (fully) on those threats.

In recent years, the Fed's language has been the subject of intense scrutiny as market participants try to read the tea leaves and determine the central bank's future actions. For much of last year, the Fed adopted a hawkish stance (both in tone and action), aimed at bringing inflation under control through aggressive interest rate hikes. In the early part of this year however, the tone became a bit more dovish. This provided some encouragement to markets, fuelling a market rally in January. US inflation data then came out in early February and indicated that inflation may be slightly ‘stickier’ than expected, leading to the Fed once again adopting a more hawkish stance, at least in terms of policy statement. But the question remains, will the Fed actually follow through with these plans, or are they simply using their tone to control markets?

First, let's examine the current economic environment. Inflation, a key concern for the Fed, has been coming off sharply in recent months. This has been a relief for many market participants, who had grown increasingly concerned about rising prices. Additionally, earnings season in the US has been surprisingly on the upside, with many companies reporting strong profits and revenue growth. While recovering from the pandemic, the job market has remained stable, with unemployment falling and wages rising.

Given these positive economic indicators, many question whether the Fed intends to follow through with its aggressive rate hike strategy. It's worth noting, however, that the Fed's primary mandate is to maintain price stability and maximum employment. Inflation, while currently receding, remains well above the Fed's target rate. Furthermore, analysts are concerned that continued economic growth could lead to further price increases. As such, the Fed may still move forward with interest rate hikes, even if the current economic environment appears stable.

Turning to the question of whether the Fed uses its tone to control markets, there is certainly some evidence to suggest that this is the case. Over the years, the Fed has developed a reputation for talking tough on interest rates but not always following through on those threats. This can be seen in the gap between the Fed's policy statements and what really transpires in the markets.

One way to measure this gap is to compare the Fed's dot plot; a chart that shows the individual projections of Fed officials for the Federal Funds rate, which is released four times per year. We can then look back historically and compare the projections of Fed officials with what actually transpired in the market during those years. In certain years, there has been a difference between these two indicators, with the Fed projecting more interest rate hikes than what actually take. For example, in 2015, the Fed projected a series of interest rate hikes, but ultimately only raised rates once in December of that year. The same is true of 2016 where rates were projected to be increased twice, but only one rate hike materialised. Similarly, in the early 2000’s, the Fed frequently discussed the need to raise rates but did not follow through with significant increases until later in the decade.

So, why does the Fed use its tone to control markets rather than following through on its threats?

One reason is that the central bank is keenly aware of the potential impact of its actions on the broader economy. Interest rate hikes can lead to a slowdown in economic growth, which can ultimately impact employment and wages. As such, the Fed may use its language to try and guide investor behaviour, without in fact making significant changes to interest rates.

Another reason is the size of the US national debt and the trajectory of interest costs. With debt of more than $30 trillion and interest costs on that debt projected to increase, the Fed has a significant incentive to keep interest rates low. Higher interest rates would increase the cost of servicing the national debt and lead to a slowdown in economic growth, making it even more difficult to manage the debt. As such, the Fed may be more likely to use its tone to control markets rather than following through on significant interest rate hikes. However, the trajectory of the national debt and interest costs is something that policymakers will need to address in the coming years, as it presents a significant challenge to the stability of the US economy.

So, why does all this matter to you and your portfolio?

Generally, rate hikes (or even the threat of rate hikes) tend to rattle equity markets. This is because the risk-free rate of return on cash increases as interest rates increase. This incentivises people to take on less risk and disinvest from equities in order to move into cash. However, it is worth noting that even when interest rates are at record highs, the real return (nominal return less inflation) on cash is often still negative. On the other hand, rate cuts (or the probability of future rate cuts) tend to boost equity markets, as the return on cash decreases. Investors therefore look for more attractive real returns and are willing to take on more risk to achieve this. Furthermore, another point which is relevant here is related to what the market expects to happen: markets price in a scenario, and the key component is whether what actually transpired is better/worse than what is expected. In the current case, higher interest rates are priced into markets. If it turns out that the tightening cycle doesn’t go as high or for as long as markets are expecting (taking guidance from the Fed), markets could rerate.

With markets it often isn't a case of whether news is good or bad but rather whether it is better or worse than expected. Therefore, in the current market - if rates are lower than expectations, markets could be boosted in a material manner.

In conclusion, while the Fed's tone may certainly play a role in controlling markets, it is worth remembering that the central bank's primary mandate is to maintain price stability and maximum employment. Consequently, the Fed may still move forward with interest rate hikes, even in a seemingly stable economic environment. That being said, evidence suggests that the Fed has a history of talking tough on interest rates without always following through on those threats. Whether or not this trend continues remains to be seen, but it is clear that the Fed's language will continue to be a key driver of market behaviour in the years to come.

This article was published on Moneyweb, 9 March 2023. To read more from Jono, click here