Federal Reserve announcement days happen eight times a year. In a press conference, the Federal Reserve chair discusses the interest rate decision and the economic forecast.
But Professor Anna Cieslak of Duke University’s Fuqua School of Business says the Fed is also communicating outside of the official press conferences in ways that have an impact on financial markets.
“There are, generally speaking, two types of news in the Fed’s communications,” she said. “One is the news moving expectations of the short-term interest rates, the other is risk premium type of news, for example via shifting market’s perceptions of uncertainty.”
In a working paper, “Tough Talk: The Fed and the Risk Premium," Cieslak and Michael McMahon of University of Oxford found that through the public speeches Federal Open Market Committee (FOMC) members give between meetings, the Fed reveals its forward-looking stance beyond what it has shared in the regularly scheduled policy announcement. This extra information, Cieslak said, significantly affects asset prices.
“It’s through this additional channel that the Fed affects the risk premium—or how much compensation investors demand to take on risky assets—in the financial markets,” she said.
How the Fed’s private deliberations reach the public
Statements released after the FOMC meetings don’t reflect the depth of the discussion. During the FOMC meeting, the committee members may express uncertainty about the reading of the economic data, and consider future policy shifts if circumstances change.
But the concise statement released on the day of the announcement reveals only a sliver of forward-looking discussions in the meeting, the researchers write. And when the more detailed minutes of the meeting are released after three weeks, the market reactions are subdued, they showed.
The researchers wondered if the content of the FOMC private deliberations filters to the public before the minutes are released through speeches by Fed governors and the other members of the committee.
Using textual analysis tools, the researchers examined the transcripts of 228 FOMC meetings from 1987 through December 2015. The transcripts are released five years after the meeting, and they offer verbatim documentation of the FOMC’s discussions. Through this language, the researchers built a numerical measure of forward looking-policy stance—relative “hawkishness” versus “dovishness,” capturing the Fed’s views beyond the official FOMC statement and the Fed’s macroeconomic forecasts. Any time the transcripts showed any expression hinting at future policy different from the policy of the statement, the researchers recorded a gap.
Cieslak and McMahon found that increased relative hawkishness recorded in the transcripts predicts a reduction in the risk premium over the intermeeting period. The economic magnitude of this newly documented effect is large. A one standard deviation increase in hawkish stance predicts a decline in the risk premium amounting to 17% of intermeeting volatility of the ten-year yield and 15% of intermeeting stock market volatility.
The researchers also examined 1,594 speeches of the Fed chair, vice-chair, and governors from 1996 and 2022, using the same approach to measure hawkishness versus dovishness in the forward-looking views beyond the policy statement.
The results of the speech analysis confirmed the findings of the transcripts, Cieslak said.
“The Fed’s communication via speeches can in principle account for the overall intermeeting effect in asset prices,” she said.
A communication channel for the Fed’s policy views
While there is a notion that interest rate cuts help stabilize financial markets and the overall economy in crises, it is not always clear that a dovish Fed policy—such as when interest rates are kept low for a long period—should necessarily reduce the risk premium and cause markets to rally, Cieslak said.
“In fact, during the recent inflationary episode through the first half of 2022, the Fed was keeping a relatively dovish stance,” she said. “But the markets were repeatedly thinking this was a mistake.”
She said that when the markets think that the Fed’s stance is not justified by the economic outlook, this belief will translate into additional risk in the financial markets.
But the researchers found that through the intermeeting speeches, Fed officials can reassure the markets that the Fed is closely monitoring for signs of a policy error and is prepared to quickly reverse course, so that any policy mistakes are unlikely to persist.
“Through its communication, the Fed can influence risk premia by acknowledging the uncertainty it faces and expressing readiness to act, should the need arise,” Cieslak said.