3 Charts That Show The Fed's Words Actually Matter

The Federal Reserve prefers to be as predictable as possible when it comes to interest rate hikes and other policy decisions. However, economic conditions can be unpredictable at times, and FOMC members have seemingly been on the fence about an interest rate hike schedule since the first hike last December.

The Federal Reserve releases quarterly Summary of Economic Projections (SEP) reports that include anonymous dot projections of future interest rates by each member. An example of an SEP interest rate projection can be seen in the first chart below.

However, between official SEP reports, Fed members also give speeches to the public that investors use to gain insight into how the Fed’s outlook may have shifted.

Prattle Analytics’ machine-learning algorithm uses the words in each communication by the Federal Reserve or its officials to generate a Fed sentiment score. A positive sentiment score indicates hawkishness, a negative score indicates dovishness and a score of zero indicates a neutral stance.

The second chart below indicates the Prattle sentiment score for the Fed headed into the FOMC meetings in September and December 2013 and March and June 2014.

The Federal Reserve Bank of San Francisco (FRBSF) recently studied the correlation between the sentiment of FOC members’ speeches in the 20 days prior to a meeting and the near-term SEP rate projections. The results can be seen in the third chart below.

“While both types of communication reveal sizable dispersion of views, the centermost point for speeches according to Prattle scores measuring their content positively correlates with median projections for the policy rate in the medium term from the SEP,” the FRBSF concluded.

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In other words, there is a statistically reliable correlation between the dovishness/hawkishness of the language in FOMC members’ speeches heading into a meeting and their subsequent medium-term interest rate projections.

This correlation suggests that traders should be paying close attention to what FOMC members are saying within three weeks of the next meeting because there’s a good chance their words will be a preview of the policy decisions ahead.