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Fed Policy Statements: What Are Words, Words, Words Worth?

Later this afternoon, the Federal Open Market Committee (FOMC) will announce the results of its previously-scheduled meeting in Washington, which has taken on new importance after yesterday’s cataclysmic sell-off that left the Dow Jones down over 500 points. Financial analysts seem to agree that the Fed has a difficult task: On the one hand, it can’t overreact to day-to-day market fluctuations with major policy shifts, but, on the other hand, inaction in the wake of this latest turmoil could rattle observers who are looking to the Fed for leadership and reassurance. As one CNBC editor puts it, the Fed is “more likely to use words than fire power to soothe markets.” But will that do any good?

According to a 2003 study by Donald L. Kohn and Brian P. Sack hosted at the Fed’s own website, the short-term impact of Fed policy statements is real. Their paper—entitled “Central Bank Talk: Does It Matter and Why?”—examined three categories of communication, including statements released by the FOMC (such as the one which will be released later today). They concluded that “the statements that accompany FOMC decisions have had significant effects on the short and intermediate-term portion of the [Treasury] yield curve and on futures rates at those horizons,” and that at one to two-year horizons, “FOMC statements account for at least as much of the movements in interest rates as the policy actions themselves.” But this is not the only significant impact of policy statements: The authors argue that statements can correct for investors’ unfounded optimism or pessimism, and they can set realistic expectations for the future of the economy. It turns out, in other words, that there may be more than just media hype to this afternoon’s pronouncement. “Statements and policy actions,” the authors conclude, “can serve as effective substitutes for one another, at least in the short run.”