The Impact of the Upcoming Federal Funds Rate Annoucement

This Wednesday the Federal Open Market Committee of the Federal Reserve will conclude a meeting and issue decisions on key pieces of monetary policy, such as the target level of the Federal Funds rate, a key benchmark interest rate in the United States. Almost every forecaster is expecting a 25 basis point increase in the Federal Funds rate, causing it to rise from 2.25 to 2.5 percent.

What will happen on financial markets if the forecasters are right?

Chances are, absolutely nothing noteworthy will happen. Since traders of stocks and currencies believe a 25 point rise will happen, they have incorporated this into their decision on what (and how much) to purchase. The price of a stock, bond, or currency does not just reflect current conditions; it also takes into account expectations of the future.

It works as such. Suppose a share of NEI is trading for $4.00 today, but traders expected that it would trade for $5.00 tomorrow. An investor could make a very quick profit by buying up shares of NEI today for $4.00 a piece, wait a day, then turn around and sell them for $5.00 the next day. So investors start to buy up the shares, driving the price of the stock up, until it reaches the $5.00 level. Thus the belief that a share of NEI would be worth $5.00 tomorrow causes it to be worth $5.00 today.

Since the market expects that the Federal Funds rate will go up 25 basis points on Feb 2, they have incorporated this into the value of assets such as stocks and currencies that are impacted by interest rates. If the market ended up making a good forecast, nothing should change when the new interest rate is announced.

What will happen on financial markets if the forecasters are wrong?

There are two possible scenarios here:

1. The Federal Funds rate goes up by more than 25 basis points
2. The Federal Funds rate goes up by less than 25 basis points (by either staying the same or decreasing, since changes are usually made in 25 point increments)

The first case is the most interesting because there a very small (but real) possibility that the Federal Funds rate will be raised by 50 points.

In this case, the market will end up being wrong, and we should expect to see a great deal of changes. Specifically such a move would strengthen the U.S. Dollar at the expense of currencies such as the Euro and the Canadian Dollar, as explained in "A Beginner's Guide to Exchange Rates". This would help shrink the U.S. trade deficit, but it would also act as a significant drag on U.S. economic growth. Because of that, neither the market, nor the author expects the Fed will take such an action.

Overall, do not expect too much excitement to follow the upcoming Federal Reserve policy announcement. It is almost certain that we will see a 25 basis point increase in the Federal Funds rate, and since financial markets expect this to happen, the announcement should have little impact on markets.

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