Interpreting Monetary Policy Communication

In my post “Watching the Central Bankers”, we cover the various ways in which central bankers communicate their thinking to market participants. But the process is far more nuanced and evolved than relying simply on official policy statements or speeches before the Rotary Club of Indianapolis. Central bankers are keenly aware that their comments have the ability to move, and potentially disrupt, financial markets all over the world. So they choose their words very carefully, leaving traders to act as interpreters. Before you start interpreting monetary policy statements and commentary, it’ll help to know the following.

Not all central bankers are created equal

The interest rate setting committees of central banks, frequently known as Monetary Policy Committees (MPCs) - the Fed's FOMC is one of these typically operate under a one-member/one-vote rule. But when it comes to delivering a message to the markets, the chairman or president of the central bank holds far more sway than any other individual member. This is partly in deference to the central bank chiefs role as first among equals, but also because that person is frequently viewed as expressing the thinking of the entire committee. Central bankers strive for consensus in reaching their decisions, and who better to represent and present this view than the chairman or president?

When the head of the central bank gives an update on the economy or the outlook for interest rates, listen up. A scheduled speech by the chair of the Fed, for instance, is likely to be preceded by market speculation similar to that of a major economic data report. And the reaction to his comments can be equally sharp.

In the case of the Fed, the FOMC is comprised of 12 voting members consisting of the board of governors and a rotating slate of regional Federal Reserve Bank presidents each year. So when a Federal Reserve Bank president is set to speak, make sure you know whether he‘s a voting member in the current year before acting on his comments.

Remarks by non-voting FOMC members are frequently discounted or ignored by traders because the speaker is not going to be casting a vote at the next meeting. But this is a bit of an oversimplification and can be risky. Before downplaying a non-voter’s comments, you need to consider her comments in the context of the FOMC consensus. Is she expressing her own views or elaborating on a shift in consensus thinking?

Birds of a feather: Hawks and doves

Central bank officials are frequently a known commodity to market analysts and traders, either from past policy statements or from their academic or policy writings prior to becoming central bankers. Markets typically refer to central bankers in terms of being hawks or doves. A hawk is someone who generally favors an aggressive approach to fighting inflation and is not averse to raising rates even if it will hurt economic growth. A dove, on the other hand, is a central banker who tends to favor pro-growth and employment monetary policy, and is generally reluctant to tighten rates if it will hurt the economy. In short, hawks tend to be fixated on fighting inflation, and doves tend to stress growth and employment.

Don’t get me wrong: There are plenty of central bankers in the middle who can wear both hats (and feathers, in this instance). In those cases, the middle-of-the-roaders tend to reveal their hawkish or dovish leanings only at the extremes of the policy cycles.

So if a hawk is slated to speak on the outlook for monetary policy, and he cites the risks from inflation or the need to prevent any increase in inflationary pressures, guess what? You’re not going to see much of a reaction from the markets because he’s a known quantity speaking true to form. You get a much sharper reaction when a hawk downplays the threats from inflation or suggests that inflationary pressures may be starting to recede. Markets will jump all over dovish comments coming from a hawk, and vice versa with hawkish comments made by a dove.