When Central Banks talk, Markets listen.

Central banks, as the sole architects of monetary policy, are so influential within the economy that their every word can have a profound effect on Markets – whether this be interest rate, currency, or equity markets. The most influential central bank (due to their economy’s sheer size) is the US Federal Reserve. Their communications have become so influential within the world’s financial markets that the committee members have had to be very careful with what they say. After some hard lessons in the 90’s, the term ‘Fedspeak’ was born, and is used to describe its very deliberate yet vague language around views on interest rate movements and monetary policy.

We must remember that Central banks have to communicate with both politicians and the broader public (including Markets). Markets (more specifically) can react violently (up and down) depending on what is said. The future direction of interest rates and anything else impacting on market supply can cause shares to rally or fall, losing or making millions or billions for those getting it right. The former chair of the Federal Reserve, Alan Greenspan decided that in order to reduce this type of volatility, he would have to code his communications, so that each market participant might think they shared his view. Sounds confusing and complicated right?

Losing Patience

Let’s look at a more recent example of Fedspeak with current Fed Chair Janet Yellen. Up until the March FOMC meeting, Janet Yellen was using the word “patience” to describe how the Fed viewed interest rates. However, in the FOMC’s March statement, “patience” was dropped. In Fedspeak, did this mean she was now “impatient”? Did this then mean that interest rates would rise soon? If so, when?… April, June, September, 2016?

You can see how something specific, but still ambiguous can cause confusion, still prevent high conviction trades and large swings in markets from occurring, yet provide a message to all. Fedspeak therefore allows central banks to gently change the direction of market thinking without any drastic intervention. This is an increasingly important tool in managing monetary policy and market expectations.

Money Supply 101

Monetary policy affects the economy in a number of ways, but all in relation to changes in money supply and its related flow on effects.

If there is not enough money in the economy it becomes expensive to borrow. Simply put, in 1989 if you were buying a house your mortgage rate would be around 17%. Compare that with today, the typical mortgage rate is around 5%.

Another way money influences the economy is inflation. If there is too much money being pumped into the economy, prices rise, causing inflation. If the inflation rate is high and volatile it becomes hard for businesses to plan and therefore reduces investment within the economy. Think of the Zimbabwe example when the government decided to print more money to pay people. The resulting inflation compounded to the point where people needed wheel barrows of money just to purchase basic household goods.

Money supply also impacts the exchange rate. A number of central banks have embarked on policy to increase the money supply via “quantitative easing” (QE). QE is just a fancy version of the before mentioned “money printing”. The difference is that central banks embark on a policy to buy bonds off banks etc rather than print the physical piece of paper. They effectively inject more money into the system, which if you think of the old supply and demand rule, means that country’s currency becomes cheaper. By using the ECB and Euro as an example, they announced in January a QE/bond buying program which would inject €60b a month into the Eurozone. The net affect has seen the EUR fall, making their imports more expensive and exports cheaper for other countries. Importing less and exporting more helps improve their local economy. More affordable Mercedes Benz, Bosch appliances etc.

Birds of a Feather

There are different theories about the role that monetary policy should play within the economy. ‘Hawkes’ believe that monetary policy should be used to keep inflation low. ‘Doves’ think that other considerations like unemployment and the economy’s growth should drive the decisions of the central bank.

In Australia, the current language of the RBA suggests that the current Board is flapping their wings as doves. This is because the Board is using language to suggest that they have inflation under control and are using monetary policy to stimulate key indicators of economic activity.

Jawboning away

In recent times, the RBA has used a different tool, known as ‘jawboning’ to influence the currency. Jawboning is to some extent the complete opposite of Fedspeak. It is clear, and concise in its meaning.

In this context, the RBA is desperate for our currency to be lower, and are doing what they can to “talk” it down. For example Glenn Stevens recently suggested that ‘fair value of the Aussie dollar’ is around 70c (vs the USD). As the RBA’s decisions impact the exchange rate, the Market makes decisions about where the dollar is heading based on what the RBA says, as the RBA has the fire power to deliver. If the RBA says the exchange rate is too high, then traders should expect it to depreciate. The RBA will make it happen one way or another; either through interest rate moves or changes in money supply, and you wouldn’t want to be on the wrong side of that.

Don’t be caught on the wrong end of the talk – learn some Fedspeak.