When the Fed says X, they really mean Y (A Handy Translation Book)

The US Federal Reserve Bank (“Fed”) is arguably the world’s most important financial decision making body. While the Fed serves many complex functions, its most important task is the raising and lowering of key interest rates, namely the discount rate and federal funds rate.

The Fed typically convenes every month to discuss interest rates. It is not only the action (whether rates are raised, lowered, or held constant), but also the accompanying “statement” which is of interest to investors and analysts. In its statement, the Fed may signal both its motivation for the current policy decision as well as offering clues towards the future direction of rates. Unfortunately, the Fed often couches its commentary in vague language and specialized terminology, which may be difficult for amateur traders and investors to understand. The following is designed as a handy translation guide for people who wish to read and understand the Fed Statement but don’t want to train for a PhD in economics.

1. Federal Funds Rate Target

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

The federal funds rate is the overnight interest rate at which banks extend overnight loans to other banks in order to meet the required reserve ratio. This is the most watched tool in the Fed’s arsenal, and most US short-term interest rates are directly derived from this rate. But why is the Fed always referring to interest rate targets, since “target” seems to suggest a future level of interest rates, rather than the present level? The reason is that the Fed does not actually set the federal funds rate. Contrary to popular belief, the Fed merely announces what it believes the federal funds Rate should be. In practice, however, this distinction is pretty meaningless; because the Fed has tremendous credibility, the actual or market federal funds rate immediately converges with the target rate.

Click to read this FOMC Statement in its entirety

2. Adjustment in the Housing Sector

Economic growth appears to have been moderate during the first half of this year, despite the ongoing adjustment in the housing sector.

The Fed is usually quick to identify adjustments in various aspects of the US capital markets. An adjustment, otherwise known as a correction, is simply a downturn in prices. Thus, when the Fed speaks of an adjustment in the housing sector, it means that housing/real estate prices are probably decreasing. This is important, because consumers typically spend more money when the market value of their assets appreciates, and vice versa when asset prices fall. The reasoning is simple enough: one certainly feels richer when his house suddenly becomes more valuable. In this case, the Fed noted that the economy performed well enough despite the adjustment, but did not indicate whether consumption (which is most effected by housing prices) contributed relatively more or less to the economy.

Click to read this FOMC Statement in its entirety

3. Tight Credit Conditions

Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.

Now, what are credit conditions and why is the Fed always referencing them? “Credit conditions” is a general term which refers to the cost of borrowing money, represented by relative interest rates. In this particular instance, the Fed was evidently concerned both about the cost of funds for businesses as well as the interest rates being paid by households. Both rates typically trade at a spread to US government bonds, which are considered to be the least risky investment in the world. When credit conditions tighten, it means investors are demanding that borrowers pay higher interest rates in order to compensate investors for what they perceive to be a higher risk of default. Thus, it is not the tighter credit conditions (i.e. higher market interest rates) which are of prime concern to the Fed, but rather the market perception that borrowers will have more difficulty in making good on their loans. In a way, this signals declining investor confidence in the economy.

Click to read this FOMC Statement in its entirety

4. Improvement in Core Inflation

Readings on core inflation have improved modestly in recent months.

Core inflation is a statistic which measures how prices are changing from month to month. It differs from “regular” inflation in that it excludes energy and food products. When the Fed indicates that core inflation has improved, it is actually saying that prices have stabilized or declined. This notion is slightly counter-intuitive, because we are used to associating improvement with an increase in something. In the case of inflation, however, lower is better, and one of the Fed’s unofficial goals is to keep inflation within a narrowly prescribed, yet unspecified range.

Click to read this FOMC Statement in its entirety

5. Resource Utilization

However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Resource utilization is among the most esoteric terms that you’ll hear the Fed use, but its meaning is surprisingly straightforward. It refers quite literally to the relative utilization, of the inputs (labor and capital) which are required to produce output (goods and services). It can be thought of as the excess capacity in the labor force or capital stock. While businesses would love to operate at full capacity, in order to minimize waste, the Fed prefers to maintain some slack in the economy in order to alleviate pressure on prices. In this case, the high level of resource utilization means that there is relatively very little spare capacity in the capital stock (buildings are full of tenants and factories are operating near full production) as well as in the labor force (unemployment is low). This phenomenon has the tendency to worry the Fed, because the high demand and low supply has the potential to drive up prices.

Click to read this FOMC Statement in its entirety

6. Firming/tightening

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth…

Firming/tightening is another pretentious phrase, used to indicate a hike, or rise, in interest rates. “Tight” monetary policy is synonymous with high interest rates, and “loose” monetary policy refers to low interest rates. The reasoning is that when rates are high, businesses and consumers are less willing to borrow, which slows the expansion of the money supply. Here, the Fed has issued a direct warning that it may have to raise interest rates if inflation fails to stabilize.

Click to read this FOMC Statement in its entirety

7. Aggregate Demand

However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.

Aggregate demand represents half of the equation which determines monetary policy, the other half of course being aggregate supply. In its most basic form, this equation relates the total/aggregate supply of capital and labor and the efficiency at which they are applied to the total/aggregate demand for the goods and services which can be produced. Basically, when demand rises relative to supply, prices rise, and vice versa. In this press release, the Fed expressed concern over rising inflation, which is why it is happy to have observed restraint in aggregate demand.

Click to read this FOMC Statement in its entirety

8. Unit Labor Costs

As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check.

Unit labor costs represent the labor costs required to produce one unit of output. This must sound rather vague, since neither the type of good/service nor the amount of output is specified. However, the term is intended to be more conceptual than practical, so it’s not necessary to get caught up in specifics. If you read between the lines of this statement, the implication is that wages must actually be increasing, and it is only because workers are becoming more productive that unit labor costs are not increasing. The Fed is concerned about labor costs because higher wages usually translate into higher prices, aka inflation.

Click to read this FOMC Statement in its entirety

9. Accommodative/easy Monetary Policy

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.

Monetary policy is accommodative when interest rates are low. The reasoning behind this term is that low interest rates are designed to “accommodate” businesses and consumers, by encouraging them to borrow money and stoke the economy. Thus, the Fed noted that its accommodative stance was expected to provide support to the economy.

Click to read this FOMC Statement in its entirety

10. Measured Pace

With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

At first glance, the term “measured pace” seems to suggest that the Fed will base its monetary policy on some kind of measurement of the economy, perhaps by observing certain economic indicators. Actually, measured simply means gradual, or restrained. When the Fed announces that it will raise or lower rates at a measure pace, it is relatively comfortable with current rates, and investors should expect rates to change infrequently, perhaps once every few months.

Click to read this FOMC Statement in its entirety

11. Sustainable Growth and Price Stability

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.

While the definition of this phrase should be self-evident, it is worth drawing attention to, because it represents a succinct version of the Fed’s mandate: to maintain economic growth at reasonable levels and to minimize inflation. In short, even though the Fed works by controlling the money supply, its goals are always economic growth and/or price stability.

Click to read this FOMC Statement in its entirety

12. Intermeeting Evidence

The evidence accumulated over the intermeeting period confirms that output is expanding briskly.

It should come as no surprise that in between meetings, the Fed summarily reviews dozens of economic indicators, which form the basis for its interest rate decisions and other monetary policy-making. These indicators include various inflation indices, consumer confidence, GDP, investment, employment data, capital flows, and many others. Fortunately, all of these statistics are available to the public, though in slightly less detailed form than what the Fed sees. As a result, economists outside the Fed have grown quite good at predicting whether the Fed will raise, lower, or maintain rates.

Click to read this FOMC Statement in its entirety

13. Geopolitical Tensions

However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets.

The Fed is only concerned with international political problems insofar as they affect the American economy. In the last few years, there have been two interrelated geopolitical risks: the potential for terrorism to disrupt the global economy and the problem of high energy prices. The Fed is especially concerned that oil prices will destroy consumer confidence and eat into disposable income such that consumers are forced to spend less in other key areas of the economy. If consumers spend less, then businesses hire less, and the problem becomes cyclical, which is why the Fed closely monitors the geopolitical situation.

Click to read this FOMC Statement in its entirety

14. Inventory Investment

However, both the upward impetus from the swing in inventory investment and the growth in final demand appear to have moderated.

As its name implies, inventory investment refers to businesses’ production/investment of additional inventory. Inventory investment is what is known as a leading economic indicator, in that it is used to predict the future direction of the economy. When businesses invest in additional inventory, it is because they expect demand to increase in the future and want to be certain that they have adequate supply.

Click to read this FOMC Statement in its entirety

15. Liquidity in the Financial Markets

The Federal Reserve will continue to supply unusually large volumes of liquidity to the financial markets, as needed, until more normal market functioning is restored.

This statement was released one week after the 9/11 terrorist attacks when the US economy, and especially US capital markets, were reeling. While the Fed is not typically concerned with the performance of stocks and bonds, in this case it was afraid that a failure to intervene would cause US capital markets to continue declining. As a result, it acted to “supply unusually large volumes of liquidity to the financial markets” by lowering interest rates. Market participants were thus encouraged to borrow money at unusually low interest rates and invest in the domestic economy.

Click to read this FOMC Statement in its entirety

Former Fed Chairman Alan Greenspan was notorious for his cryptic speeches and thus far his replacement, Ben Bernanke, doesn’t seem to be much clearer. Now that you’re armed with this handy translation book, however, the next time the Fed says something that sounds more like Greek than economic forecasting you’ll not only understand what they mean, but also be able to make smart investment decisions using that information.