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Must-know: Impact of Committee and market reactions

Mayur Sontakke

Dr. Stein on monetary policy communication: Overview (Part 5 of 8)

(Continued from Part 4)

Interplay between the Committee and the market

The Federal Open Market Committee’s (or FOMC’s) actions don’t happen in isolation. FOMC makes its policy decisions based on the market scenario. The market reacts to FOMC’s monetary policy decisions, which makes the feedback process a vicious cycle between FOMC and the market.

FOMC has relied significantly on signals from the markets while making decisions related to Quantitative Easing 3 (or QE3). In turn, the market has relied on the forward guidance to judge the Committee’s intentions related to the future path of the federal funds rate.

Dr. Stein argued that if the Committee is using asset purchase program-related decisions to signal its policy intentions, the informational value of the purchase decisions depends on what the market expects the Committee to do. The more the markets attach to their belief on possible Fed actions, the greater impact an unexpected change will have on the markets. In such scenario, the Fed would likely try to go by the market expectations and enforce the initial belief of the market.

Chairwoman Janet Yellen mentioned, at the press conference after the March meeting, that the rate hike may start roughly six months after the end of bond buying program. The statement took the bond market (BND) by surprise because investors were expecting that the rate hike wouldn’t start before the end of 2015. The possibility of an earlier-than-expected rate hike caused havoc in bond markets, which led to a drop in the prices of bonds and bond ETFs such as the iShares 20+ year Treasury Bond (TLT), the iShares 7–10 year Treasury Bond (IEF), the iShares 3–7 year Treasury Bond (IEI), and the iShares iBoxx $ Invst Grade Crp Bond (LQD) on March 19.

To learn about why the market is expecting the taper to continue, continue reading the next part of this series.

Continue to Part 6

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