The Federal Reserve: seen by some as an economic savior, and by others as an evil force.Through its direct manipulation of interest rates and other mechanisms, the Federal Reserve determines the overall pace of U.S. economic growth (or decline).
Since investors trend toward euphoria when times are good & panic when times are bad, the Fed’s mandate is to control the economy; for example, to stimulate a weak economy by lowering interest rates, or to slow down an overheated one by raising interest rates. Yes, that's right – the Fed sometimes purposely initiates recessions. This is not conspiracy, but rather a method of controlling human stupidity (or at least cleaning up after it).
In good times wages tend to increase, which in turn increases spending, which increases prices of goods, which increases stock and real estate prices, which induces inflation, which causes wages to increase and so on. When times are good and voters are happy, the government wants it all to continue. If an independent Fed did not exist, human greed and optimism would allow bubbles to grow to stratospheric levels, then come crashing horribly down. The recent crash and burn of the U.S. housing bubble is an example of the Fed's failure to do its job – it let the bubble grow for too long.
Importantly, while the Fed always hints at what it wants to accomplish in the future, it does so in a cryptic manner. So, while the Fed’s intentions may be crystal clear to professionals, they pass by virtually unnoticed to non-professionals – exactly as intended.
Buying reasonably priced stocks of good companies is always a good idea, but it’s an even better idea to buy them when the tide of the economy is moving with you. The purpose of this article is therefore to teach the rules of “Fed speak,” the cryptic voice that shapes the nation’s economy.
Rule #1 - The Fed Understates Everything
The Fed is aware of its huge influence in the market, and takes care not to overstep its boundaries. If the Fed simply said, for example, “we intend to raise interest rates because we think there is a bubble in technology stocks,” the market would likely dive and the Fed would be blamed. For this reason, the Fed avoids stating anything of importance directly. Thus, “this market has a bit of froth,” really means, “this is a bubble of massive proportions.” Asking, “Is there a reason to think that homes are overvalued?” means that homes are terribly overvalued. Whenever the Fed states or suggests an opinion, you can safely magnify it tenfold.
Rule #2 –Recognize Moral Suasion
Moral suasion, also known as “jawboning,” is the name for scolding market participants in order to change behavior. By sending a warning to the market, the Fed hopes that it can delay or even avoid taking a negative course of action.
For example, in 2009 the Bank of Canada (Canada’s equivalent to the Fed) stated, “the recent sharp increase in the value of the Canadian dollar, if it proves persistent, could fully offset recent positive developments in financial conditions, commodity prices, and confidence.” This stern warning (see Rule #1) told market participants that if they keep buying the Canadian dollar, the Bank will take measures to devalue it (to improve exports).
In the long run moral suasion rarely works, but in the short run it can have the desired consequences. Moral suasion also indicates the course of action the Fed will take if moral suasion fails.
Rule #3 – Read the Speeches Verbatim
The introductions and conclusions of Fed speeches are made for public consumption (the media) and generally reflect useless broad opinions (such as, "the economy is improving.")
The subtle nuances with true predictive value are in the carefully chosen text. For this reason, any online news article about a Fed speech will include a link to the Fed’s word-for-word text. This verbatim text is meant for market professionals.
Examples of Fed Speak in Action:
“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
Alan Greenspan, Chairman of the Federal Reserve Board, 1996 Speech
Translation: Stocks appear to be grossly overvalued (the Internet bubble).
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"It's pretty clear that it's an unsustainable underlying pattern. People are reaching to be able to pay the prices to be able to move into a home."
Alan Greenspan, Chairman of the Federal Reserve Board, 2005 Speech
Translation: There is a housing bubble in the U.S., and it will crash.
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“With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”
Bank of Canada, Press Release, Apr 2010
Translation: We will be raising interest rates soon.
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The importance of understanding the Federal Reserve cannot be underestimated. To a large extent, the Fed determines the near-term growth or contraction of business, and therefore the direction of the stock market. In addition, the Fed is a reliable asset bubble "early warning system." Learning to speak Fed can save you a lot of anguish.
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“Augmenting concerns about the Federal Reserve is the perception that we are a secretive organization, operating behind closed doors, not always in the interests of the nation as a whole. This is regrettable, and we continuously strive to alter this misperception.”
Alan Greenspan, Federal Reserve Board Chairman, 1996
