The Fed's Two Tools: The Rate and Its Words

Lesson 2.2 called the committee's rate the throttle, and it is. But look at what it actually is: a target for the rate banks charge each other to borrow money overnight. One number, one night. No one you know borrows overnight from a bank.

And yet on the afternoon that number is announced, thirty-year mortgages reprice, stock indexes swing, the dollar moves against every currency, and gold jumps or falls. Things that have nothing to do with overnight bank lending move in the same minute. Sometimes they move most on days the number doesn't change at all.

So the committee has a second tool, and it's the one this lesson is about. The question: if the committee only sets one overnight number, how does it move a thirty-year mortgage, a stock index, and a currency in the same afternoon?

London, July 26, 2012. A conference hall full of investors, and the euro is coming apart. Spain is paying nearly seven percent to borrow for ten years, and the arithmetic of lesson 2.3 is running: at that rate the pile can't be carried, and everyone in the room knows it.

Mario Draghi, not yet a year into running the European Central Bank, isn't scheduled to announce anything. He gives a short speech. In the middle of it he says: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

No program. No number. No bond bought that day, or that month. The mechanism that the words implied, a promise to buy the bonds of any country that asked, was announced in September and never used once. Not one purchase under it, ever.

And Spain's ten-year yield went from six point eight percent in July to five point three by December, to four point seven the next summer, to one point two by the spring of 2015. A sentence took two thirds off a country's borrowing cost. A promise that never had to be kept did what no purchase had, and it worked precisely because everyone believed it would be kept.

Ten years later, the same tool, pointed the other way. Jackson Hole, Wyoming, August 26, 2022. Jerome Powell has been raising rates for five months and much of the market expects him to ease off soon.

He gives a short speech. In it: higher rates and slower growth "will also bring some pain to households and businesses." And: "we must keep at it until the job is done." And: "The historical record cautions strongly against prematurely loosening policy."

The rate didn't change that day. The S&P 500 closed down three point four percent. The market had been pricing a committee that would blink. In one speech it repriced to one that wouldn't. The rate went on to five and a third the next summer, exactly as the words said.

Ask the tycoon's question. Who made the rule? A committee, by choosing sentences. Who gained? In 2012, every holder of Spanish debt, and the Spanish treasury most. Who paid in 2022? Everyone long the future on a Friday morning who'd bet on a blink. In both cases the price moved before a single dollar did.

The committee has two tools. Everyone can name the first. Almost nobody can explain why the second is the bigger one.

Tool one is the rate. The committee announces a target range for the federal funds rate, the rate banks charge each other for overnight loans, and then trades in the market to hold it there.

That rate is the floor under every other rate in the country, and it reaches the economy the way lesson 2.2 described: loans reprice as they roll, over a year or more. Slow, heavy, and certain. Nobody escapes it, and nobody feels it the day it moves.

Tool two is the words. The statement, a few hundred words released with the decision. The press conference after it. The projections, released four times a year, where each member marks a dot for where they expect the rate to be.

And the speeches in between. Together they tell the market where the rate is going, not where it is.

Economists call the whole practice forward guidance, which just means steering the market's expectations on purpose, and it became a formal tool only after 2008, when the rate hit zero and the words were what was left.

Here's the bridge, and it's lesson 3.3's curve. The rate moves the overnight number. The words move the market's guess at the next two years of overnight numbers, and that guess is the two-year yield, which sets the ten-year with the term premium, which discounts everything on the board by lesson 3.1's formula.

The rate moves one night. The words move the whole curve, and the curve is what prices your mortgage, your stocks and your business.

That's why Draghi's sentence cut Spain's cost by two thirds without a purchase. The market's guess at what the ECB would do changed, so every Spanish bond was repriced against the new guess. It's why Powell's speech took three percent off the index on a day the rate sat still. The guess at the next two years moved, and the guess is the price.

Now the constraint, the thing that stops the tool from being free. Words only work if past words came true. A committee that says higher for longer and then cuts at the first wobble spends its credibility, and the next sentence moves less.

Draghi's promise worked because the ECB could have bought, and everyone knew it. Powell's worked because the Fed then did exactly what he said for a year. The words are a tool because the rate is behind them. Neither works alone.

And one more piece, the practical one. On the day, the number is old news. It's been priced in for days from the speeches and the futures market, where traders bet on the rate at each meeting and the odds are public.

By the morning of the decision those odds usually sit near certainty for one outcome, which is why the number itself lands like a formality. The desk reads the number in two seconds. It reads the statement for twenty minutes, next to last meeting's, looking for the sentence that changed. That sentence is the price.

Spain's ten-year yield, monthly, from 2010 to 2016. Find July 2012 on the line. Everything after it's a sentence, because nothing was bought. That's the cleanest picture of tool two the record has.

Now what an American Fed day is actually made of, and what each piece moves.

The decision moves almost nothing, because the market has already priced it. The statement moves the two-year in minutes, because the market reads the difference against last meeting's text and reprices the next two years of policy on the changed words.

The projections move the whole curve on the median dot. The press conference moves everything long, because forty minutes of questions usually lets one unguarded sentence out. The speeches between meetings move whatever the market wasn't expecting, which is how Jackson Hole became the most watched afternoon of the year.

Read this against the week. The committee meets Tuesday and Wednesday. The statement lands at two. The desk's board from lesson 2.5 has the overnight rate at three point six three and the ten-year at four point nine five. Whatever the number is at two o'clock, the market will have guessed it. What it can't guess is the sentence, and the sentence will move the ten-year, and the ten-year is what discounts the board.

The incentive map. Who chooses the words? A committee that knows exactly how much they move, which is why every one is drafted. Who gains when the words say cut? Everyone long. Who gains when they say hold? Everyone short, and every holder of the money. Who pays for a word that turns out to be false? The committee, in the only currency it has, which is the next word.

Here's the reveal. The committee's real tool isn't the rate. It's the market's belief about the rate, and it moves that belief with sentences, so the most important thing that happens on a Fed day is a diff between two paragraphs. The number is the past. The paragraph is the price.

A digital tycoon can't set the rate and can't write the statement, but he can read both, and the second one is where the edge is. Three reads.

First, read the diff, not the decision. On a Fed day, put last meeting's statement next to this one and find the changed sentences. That's what the market is doing, and it's a five-minute job with two public documents. The number you already knew.

Second, treat the words as a forecast of the rate, not as the rate. Lesson 3.3's curve is the market's version of that forecast. When the words and the curve disagree, one of them is going to be wrong, and the desk writes down which one it thinks, and dates it.

Third, know that the tool cuts both ways. Draghi's sentence was the biggest gift a bondholder ever got. Powell's was three percent off everything long in an afternoon. A book sized to survive a sentence is the office's rule, not a forecast of which sentence.

Our paper fund reads it by its rules: a written reason on every move, no leverage, so no sentence can force a sale, and the score kept against an asset that has no committee and issues no statements at all.

• Mario Draghi, Global Investment Conference, London, 26 July 2012: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." The speech names no program. ECB.
• Spain, 10-year government bond yield, monthly (IRLTLT01ESM156N): 6.79 percent in July 2012; 5.92 in September; 5.34 in December 2012; 4.67 in June 2013; 1.79 in December 2014; 1.23 in March 2015. FRED.
• Jerome Powell, Jackson Hole, August 26, 2022: "While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses." "That brings me to the third lesson, which is that we must keep at it until the job is done." "The historical record cautions strongly against prematurely loosening policy." Federal Reserve Board.
• S&P 500: 4,199.12 on August 25, 2022; 4,057.66 on August 26, 2022; −3.4 percent. FRED.
• Federal funds effective rate: 0.08 percent in February 2022; 0.20 in March 2022; 5.33 percent in August 2023. FRED.
• The FOMC meets eight times a year; the September 2026 meeting is September 15 to 16, with the statement at 2:00pm ET and the press conference at 2:30pm. Federal Reserve Board calendar.
• The Outright Monetary Transactions program was announced by the ECB in September 2012 and has never been activated. Stated as the desk's reading of the public record; the Draghi speech itself doesn't name it.