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Investments

The most powerful weapon in the Fed arsenal

November 25, 2013
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Last week, the nomination of Janet Yellen to head the Federal Reserve came one step closer to becoming a reality.

The Senate Banking Committee voted in favor of the nomination, a huge boost of confidence in the ability of Janet Yellen to talk through monetary policy. And during that nomination hearing, Yellen evoked the stock market when talking about quantitative easing. Here's why that seemingly minor connection is actually pretty huge.

It's an important distinction to note the there are some things Yellen will do more of than her predecessor. Yellen is seen as more-or-less a mirror version of the current Fed Chair Ben Bernanke. She will apply the same standards of relying on macroeconomic factors to drive the eventual decision to wind down the Fed policy of buying Treasurys and mortgage-backed securities.

While the taper is expected early next year, Yellen faced questions on the logic of this program in the hearing. As this article in the New Yorker points out, the senators implored Yellen on whether this monetary policy is driving the markets to bubble.

"The objective here is to assure a strong and robust recovery so that we get back to full employment," Yellen said. "Stock prices have risen pretty robustly," she added, pointing out that she didn't "see stock prices in territory that suggests bubble-like conditions."

Author Kirk Kardashian later opines: "Yellen would do well to acknowledge that the Fed’s current policies may not be working as well as they should."

I would argue that, Yellen, in fact does. Her comment on stock prices clearly admits there is a level of Fed-involved volatility. And to focus on the stock market, when discussing the Fed's involvement in the fixed-income markets, shows Yellen is well aware the most powerful tool of the Federal Researve is effective communication.

Bernanke didn't always hold press conferences after releasing Federal Open Market Committee statements. Yellen sees the logic in effectively communicating efforts in order to reduce volatility.

During tapering, this would be an area where Yellen will become a better fit than Bernanke. A Liberty Street Economics blog posted today on the website of the Federal Reserve Bank of New York, by analysts Fernando Duarte and Carlo Rosa, takes a look at market reactions during differing FOMC announcements; the released statement and then the Q&A with the press.

They basically compare market reactions during the course of the two announcements and benchmark behaviors to instances where there is a statement, but no ensuing Q&A.

Cleary the bond markets react to the statement. Yet, interestingly, the stock market reacts during the Q&A.

"The 'announcement effect' we uncovered isn’t unique to equities," Duarte and Rosa write. Indeed, even exchange rate trading is impacted. That's a much broader reaction than just stocks and bonds.

Duarte and Rosa conclude "there are several important communication tools at the disposal of central bankers throughout the world."

"This is particularly relevant in today’s environment of unconventional monetary policy, in which there are multiple dimensions of decision making that need to be conveyed to the public," they said.

Unconventional monetary policy may still comprise the backbone of the daily markets, but the real heartbeat comes from the ability of the Federal Reserve to fully communicate its activities and strategies.

Clearly Janet Yellen appreciates that communication is the most powerful weapon in the Fed's arsenal.

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