Brian Kettell gained his experience of financial markets working for Citibank, American Express and Shearson Lehman and and currently works as Economic Advisor to the Central Bank of Bahrain. He has published 11 books on financial markets and has taught at the London School of Economics, London Guildhall University and the City University of Hong Kong. He has run training programmes for clients which include Chase Manhattan Bank, Morgan Stanley, Kleinwort Benson, Nomura, Banque Indosuez and Barclays Capital.
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Remember the central role of nominal/real GNP quarterly growth.
The Fed Watcher must project and interpret developments other than Federal Reserve policy that are likely to affect future economic conditions and interest rates. The semi-annual Humphrey-Hawkins Testimony sets out the Fed central targets and projections for nominal GDP, real GDP and the Personal Consumer Expenditure (CPE) Price Index. If the nominal GDP growth appears to be overshooting the target there is pressure for the Fed funds rate to rise. Similarly if there appears to be undershooting there is pressure for the Fed funds rate to fall.
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Track the yield curve if you want to predict business cycle turning points.
It has been recognised for some time that the yield curve, which shows the term structure of interest rates prevailing in an economy at any point in time, contains information that can be used as an indicator of economic prospects. This is because the term structure reflects both the settings of the instruments of monetary policy, as shown in the level of short-term interest rates, and the market's expectation of future short- term rates, and hence of future growth and inflation.
Historical experience shows that on several occasions prior to recessions, long term interest rates dipped below prevailing short term rates, a phenomenon known as an inverted or negative yield curve. Since 1960 the yield curve has been inverted prior to all five recessions. The extent to which the yield curve is tilted away from its normal 'shape' has been identified by many researchers as a valuable indicator of forthcoming recession .
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Watch what the Fed watches - not what you think it should watch.
In tracking and anticipating the trend for interest rates, begin with a close reading of the most recently released Federal Open Market Committee (FOMC) minutes. Try to understand the Committee's concerns and the balance of opinion among its members . The FOMC minutes will emphasise different measures of inflation such as non-farm payroll employment or the consumer price index, different monetary aggregates or the behaviour of nominal gross domestic product that will influence a policy change. These indicators should be watched closely.
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Keep an eye on the 3-month Euro-Dollar futures contract.
This contract is amongst those financial instruments most sensitive to Fed funds rate changes and indicates what investors think three-month deposits will cost when the market expires . It is expressed as: 100 - the annualised interest rate. So if the 3 months contract is priced at 95.00 this indicates an expected 3-month interest rate of around 5%. Clearly if the contract price rises above 95.00 interest rates are expected to fall and if the contract price falls below 95.00 then interest rates are expected to rise.
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Use Taylor's Rule as a guide to changes in Fed policy.
John Taylor, an economist at Stanford University, suggested short-term nominal interest rates should be equal to the sum of four elements:
The first is the real short-term rate that is consistent with 'neutral' monetary policy - i.e. one that is neither expansionary nor contractionary.
The second is the expected inflation rate.
The third, in the simplest and most common version of the Taylor rule, is that 0.5 percentage points should be added to, or subtracted from, short-term rates for every percentage point by which the current inflation rate is above or below its target.
The fourth is that the same adjustment should be made for the 'output gap' - i.e. for every percentage point by which GDP is above or below its long-term trend level. The idea is that output above trend is a signal of inflation on the way; below trend, the reverse.
Several studies have found that central banks have, in effect, been following the Taylor rule for some time.
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Pay attention to what the Fed does - not what it says.
This may sound rather obvious but it is not necessarily the case that the Fed does what it says it will. Former Fed Chairman Arthur Burns (1970-1978) and G William Miller (1978-1979) both talked of the need for restrictive action but did very little. It must be said however that the same charge cannot be made against either Paul Volcker (1979-1987) and Alan Greenspan (1987 - ).
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View potential Fed policy shifts as a reaction to, rather than a cause of, undesired economic/monetary conditions.
Alan Greenspan has frequently referred to the economy being the patient whilst the Fed is the doctor. If the patient is hyperactive the doctor should take the appropriate action. As former Fed Chairman William McChesney Martin (1951-1970) famously commented, "The role of the Fed chairman is to take away the punch bowl just as the party is starting."
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Remember that ultimately the Fed is a creature of Congress.
Although insulated in the short-term from partisan political pressures it is not insulated in the longer term. The limits of its independence are clearly delineated. The Fed was created by an act of Congress and, like any agency so created, can be changed or terminated altogether by Congress. What Congress creates it can also destroy!
So although the Fed receives its mandate from Congress regarding what it should try to achieve with monetary policy over time, these decisions are subject to Congressional Review. Former Chairman Martin liked to describe the Fed as "independent within the government, not of the government".
A new US president is likely to be able to choose several governors for the Fed during his or her term of office. Through the choice of nominees, the president can influence the direction of monetary policy. President George W. Bush is in the unusual opportunity of influencing the selection of a large number of governors.
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Follow the trends in FOMC Directives.
At each meeting the FOMC issues a policy directive, the language of which determines whether the directive was symmetric or asymmetric. One of the most important decisions reached at Federal Open market Committee (FOMC) meetings is whether to ease or tighten monetary policy. The FOMC transmits its decision to the Federal Reserve Bank of New York (where open market operations are actually executed) in a domestic policy directive that guides monetary policy in the subsequent weeks.
Policy directives express the preference of the FOMC for the implementation of monetary policy during the period until the next FOMC meeting. Symmetrical directives express no bias toward either greater ease (a lower federal funds rate) or toward greater restraint (a higher federal funds rate).
Asymmetrical directives do express a policy bias. By writing an asymmetrical directive, the FOMC empowers the chairman to raise or lower the federal funds rate target during the intermeeting period.
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Fears of inflation provoke faster changes in monetary policy than do fears of unemployment.
The reasoning behind this rule comes from Alan Blinder, former Vice Chairman of the Board of Governors of the Federal Reserve, in his publication 'Central Banking in Theory and Practice (1998)'. He discusses the extent to which monetary policy should take the form of a 'pre-emptive strike' when faced with fighting either inflation or unemployment. Blinder argues that the lags in monetary policy could be longer for inflation fighting than for unemployment fighting, calling for earlier pre-emption in the former case. He then cites empirical evidence that supports his views.
