Why do investors care so much about what central banks say ?

Have you ever wondered why a single speech by the chair of the federal reserve or the president of the European central bank causes an uproar – what we call market volatility - in the stock markets? Or why it causes currency values to violently swing, even when nothing’s changed – be it laws, policies, interest rates?

Before we delve into that, let’s take a look at what central banks actually do. Mostly, they control monetary policy, which is a set of strategies and actions they implement to achieve their macroeconomic goals, like low inflation and stable economic growth. They also print money, thereby controlling the supply of money in the economy. But the role that we’ll be exploring today is how they manage the expectations of economy.

Imagine a morning in your school assembly. If the room was really loud, the principal wouldn’t dish out detentions, he’d give people a heads up, something along the lines of ‘if this noise continues, I’m going to start handing out detentions’. This would cause immediate change, even if he hadn’t actually done anything. In the economy, consider that principal to be the central bank, and the students to be the people in the economy. A ‘heads up’ like that would be called forward guidance, and it is one of two reasons that what the central banks say matter so much. For institutional investors especially, this anticipation of a policy shift is the difference between securing alpha (outperforming the market) or suffering catastrophic losses.

Transparency by the central banks to the economy acts as a monetary policy tool itself – that is what forward guidance actually is – a communication strategy whereby central banks signal future monetary policy path (such as low interest rates). Investors care about this because of markets being inherently forward looking.

A textbook example of this was in 2015 under Janet Yellen, the then chair of the Federal Reserve. Consider the formula for stock valuation using the Dividend Discount Model:

Where:

• P₀ is the stock price

• D₁ is the expected dividend for the following year

• r is the required rate of return

• g is the constant growth rate.

Discount rate (r) is heavily tied to the rate of return, which is generally risk free and is determined by the central bank’s benchmark interest rate. In 2014, the Federal Reserve started using the word ‘patient’ with relevance to the interest rates. However, when they released their policy statement the following March, the word patient was no longer there. The market interpreted this to be a hawkish pivot, that is to say, a sign that interest rates would rise. Did the rates rise at that point? No, but it caused an immediate uproar in the economy, with largely fluctuating stock prices, and the US dollar reacting aggressively against foreign currency. Investors raised the value of their r, which shrank the intrinsic value of the stock, sparking immediate market-sell offs without the bank actually changing anything.

However, the only reason forward guidance works is due to the Rational Expectations Theory. In modern economics, it is a foundational theory stating that individuals and businesses make decisions based on all available information, past experiences, and a sound understanding of how the economy works. It relies on the belief that people are forward-looking and will adjust their behavior to respond to new data. If investors didn’t act on this, they would only look backward (this is called acting on adaptive expectations). They would wait until the central bank actually did something, see the result, and adapt to it. But because people are forward-looking, they can listen to a speech or read a document by the central bank, analyse the data, and make predictions about the economy in the future.

To summarise , investors hang on to the words of central banks so much because they control so much in the economy, and based off of the data that they provide, investors can predict the state of the economy in the future.