Markets’ Obsession with the Fed

This week on Wednesday 21-September the Federal Reserve (the US central bank) will announce its decision on interest rates. All markets are watching Fed decisions. The level of short term interest rates in the US has of course a direct impact on yields (and prices) of US treasury bonds. It has also a majour impact on stock markets, and it does so in several ways. It determines the interest rate investors are charged when they borrow money to invest it stocks, bonds and other financial instruments. The profitability of commercial banks in the US is also largely dependent on the Fed-funds rate. But more importantly it influences the economic activity overall. Changes in interest rates also give an important signal about the state of the economy. The US being the largest economy in the world, the US stock and bond markets being so huge and having investors from around the world, the impact of that decision go well beyond the US borders.

Capital market professionals – brokers, asset managers, economists, commentators, etc. – naturally pay a lot of attention to the decisions taken at Federal Open Market Committee meetings, as well as to the Committee’s economic forecasts. A big part of these market professionals tend to criticize the Fed and to express opinions as to what the Fed should or should not do. Many economists, strategists, investment managers make it sound as they know better than the Janet Yellen (Fed Chairwoman). And I have to admit sometimes I do the same – I think I am right and the 12 members of the FOMC are wrong. For example, think they should have raised rates earlier. But let’s face it. However depressing for our own ego, it is very unlikely that any one of us, and even any team of economists in a bank, is smarter, better informed and more knowledgeable on the economy than the members of the FOMC.

It all comes down to who those people are and how have they been selected and appointed at their roles. I do believe the selection process for Fed governors in the US is transparent, democratic and ensure the best people are appointed. Furthermore, it is never only about one person. People tend to focus on the Fed Chairman. But the interest rate setting committee is composed of 12 members. Four of them are Chairman of regional Fed banks, and vote on a rotating principle. That ensures diversity of view. However influential the chairman may be, each member is free to have his own independent opinion and most if not all members do. And most importantly all FOMC members are probably much better economists than 99,9% of those working at brokers and investment banks.

Ms. Janet Yellen has been saying for more than a year now that Fed decisions to increase interest rates will be “data driven”. Many focus on the impact of higher interest rates on financial markets, but they very often tend to forget the other side of the coin. If the Fed increases rates it’s probably for a very good reason. It probably means the US economy is doing well, which should be good news for stock markets. Investors may end up paying a bit more on borrowed funds, but the return on their investments is likely to be even higher.