The Financial Times article analyses the Fed’s decision to leave interest rates unchanged as of 15th of March 2016. This decision not to act had wide implications, and stock markets rallied in response. Read the article carefully, and concentrate on the following points:
? The Federal Reserve has left interest rates unchanged at 0.25 to 0.5 percent, but it has also lowered its forecast for 2016 as a whole by 0.5%. While this is not a policy setting, the forecast gives the market insight into the likelihood of future increases. As these increases are to be smaller than previously expected, the credit available on the market is likely to stay cheaper. As such, the required rates of return demanded by investors will stay lower, making all equities and bonds more valuable. That explains the stock rally that followed the announcement.
? Notice how carefully the article follows the language of the official statement, made by Chair of the Fed Janet Yellen. She states that this change will “allow us to verify the labour market is continuing to strengthen despite the risks from abroad.” The language is very carefully crafted, and many investors read into it. It is interpreted as: “If there weren’t outside risks, we would probably increase the rates, but let’s wait for now.”
? The decision was understood by the markets as very dovish, which means it leans towards easing of the policy.
? The Fed also published its projections for the upcoming years, in the form of a dot chart. Individual dots represent individual Fed governors’ expectations of the rates in the future. This projection is the latest form of forward guidance aimed at lowering uncertainty in the market about the future rates.
? Market analysts now expect only one increase this year, with only 22% of analysts expecting two or more increases. The next increase is expected in September 2016.
? The main factors in the Fed’s decision were continuously low inflation and the slowdown in developing economies. At the same time, already low unemployment so far hasn’t translated into an increases in wages. So, the Federal Reserve has decided to wait and see if slow increases in inflation and a small wage pick up will translate into a stronger trend before it acts. Please note how carefully all macro trends are considered and how much weight every word said by Janet Yellen is given That is because any potential change in interest rates forces investors to re–value all investments in their ownership, as well as the ones they are contemplating making. For this reason, even these small percentage movements have significant impacts on values and returns.
Question
1. If the Federal Reserve increased the rates unexpectedly, what would most likely happen on the stock markets? Explain.
2. If there weren’t any forward-looking guidance or any other future rate projections, what would be the most likely impact of this lack of guidance on investments?