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The Fed’s Decisions and Stock Volatility

November 02, 2015

In September, the Federal Reserve announced it would keep short-term interest rates near zero, where they have been for almost seven years. Amongst other issues, the Fed cited weaker economic growth abroad (particularly in China) and sluggish inflation, arguing that these factors could create major impediments to growth. Today, we examine this decision in the context of stock volatility and discuss how and why the markets reacted yesterday to the Fed’s latest meeting.

The Decision’s Economic Context

Interest rate manipulation has a direct and tangible impact on the supply of money in the economy. By setting the short-term interest rate (also called the federal funds rate, or FFR), the Fed is able to alter the money supply in response to the economic climate. The FFR is the rate at which banks lend money to one another; it also is the default interest rate banks deliver to consumers. When the Fed increases interest rates, individuals and businesses are motivated to save, rather than spend, because a higher interest rate means that saving money in the bank provides a higher return. On the other hand, lowering interest rates motivates greater spending, for it makes it less expensive for individuals and business to borrow money.

How, then, do these changes in spending and saving impact the prices of stocks? From a financial perspective, an increase in interest rates makes borrowing money from banks a less attractive option for businesses. If companies aren’t able to borrow as much, they can’t invest in new growth opportunities, which results in decreases in profits and future expected profits. The stock price, at its most basic interpretation, represents the cumulative present value of all expected future dividends (the amount the company pays out to stockholders). A decrease in profits decreases these expected payouts, resulting in lower stock prices. Applying this analysis to the market level, if enough companies experience a decline in stock prices, the value of the market (measured through indices such as the S&P 500), will decrease.

Volatility

The Federal Open Markets Commission’s—the commission that actually decides whether or not to change the interest rates—decision therefore has tremendous implications for the market. Let’s explore how the release of the FOMC minutes impacts the volatility of stock prices. Though defined measures of volatility exist, it’s useful to think of volatility as the standard deviation of stock returns. The higher the standard deviation, the greater the volatility, since the returns deviate from the average by a larger amount.

Intuitively, the release of the decision should increase volatility. After all, a change in interest rate, if any, forces investors to reevaluate their current investments, and realign their portfolio with updated expectations regarding the future. Historically, this intuition seems to hold true. Statistical analysis of five-minute or high-frequency price data on stocks (and other assets) reveals that the standard deviation of stock price returns increases after the release of the FOMC minutes. Specifically, the graph below plots the standard deviation of the high-frequency stock price returns around the release of the FOMC minutes. The use of five-minute stock price returns controls for possible random variation that may occur throughout the day. Note that the sharp increase in volatility after the release of the FOMC minutes represents a statistically significant increase. These findings indicate that the FOMC minutes provide market-relevant information, which investors then internalize to inform their investment decisions.

 

(Image: Standard Deviation of Stock Prices. Source: New York Federal Reserve)

It’s important to note, however, that though volatility is associated with disorder, volatility in the markets doesn’t persist. Rather, the initial effect of the decision will create a short-term spike in volatility. Then, the market, taking into account the additional information generated by these changes and subsequent commentary, will seek a new equilibrium. That is to say, the FOMC decision can affect stock prices immediately, but the market will move back toward an equilibrium. In the graph above, we see that the initial spike in the standard deviation is quickly followed by a new level of market uncertainty.

September FOMC Meeting

To extend the analysis to the September FOMC decision, we can look at general market indices to get a macroscopic perspective on market volatility. Initially, stock markets gyrated after the announcement, with the Dow Jones Industrial Average falling about 0.4%, or 65.21 points. Furthermore, as the graph below shows, these declines persisted for a little less than two weeks afterwards. It’s likely that, in addition to the more-or-less random motion of the stock market, the market took this time to adjust to the decision.

(Image: Dow Jones Industrial Average Price. Source: Market Watch)

Similarly, as Figure 3 shows, the S&P 500 was similarly jolted, losing 5.7% by closing on the day the decision was announced. Again, the declines persisted for about a little less than two weeks, after which stocks began to rebound. The rebound indicates that investors and the market have internalized the new information and moved toward equilibrium once more. 

(Image: S&P 500 Price. Source: Market Watch)

October FOMC Meeting

Now, let’s look at what happened on Wednesday. After every meeting, the Fed releases a press release to the public containing the economic indicators that will influence their decision in the future, usually inflation and unemployment. On Wednesday, the Fed had a meeting and (as expected) announced that they will not raise rates for now. From the explanations above, you would expect the stock market to either not react as this was the expected decision or to move upward as uncertain investors gained confidence. However, from the day’s snapshot of the S&P 500, we can see a drop in the price immediately following the Fed’s announcement at 2pm.

(Image: S&P 500 Price, Wednesday 10/28/2015. Source: Market Watch)

The only reason the markets would react unfavorably is if there is an expectation of an upcoming rate increase. To find the source of this updated thinking, we have to look into how the Fed manages the public’s perceptions and expectations. After every meeting, the FOMC publishes a press release that people study (down to every word) in order to have a sense of what the future holds. For example, the FOMC explicitly stated that it will be “determining whether it will be appropriate to raise the target range at its next meeting,” which implies that there is a reasonable chance for a rate increase in December. In addition, the removal of explicit language regarding economic concerns abroad intimates a clearer focus on domestic concerns, again increasing the likelihood of a rate hike sooner rather than later. Finally, there are a couple statements regarding unemployment that seem to be preparing us for an upcoming rate increase.

Understanding the theory behind stock volatility after a Fed meeting as well as the qualitative analysis that goes into looking at the actual language of press releases is key to understanding why markets react the way they do. Predictions about market reaction can be made by doing exactly what traders and brokers throughout Wall Street do after each FOMC meeting: look at both the dot plots and the press release to attempt to deduce the Fed’s thinking. As noted by Wonk Tank earlier, December will be the meeting to watch!

Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

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