The last month has been something of a cliffhanger for Fed watchers. But today the market seemed to make up its mind.
The federal funds rate is an overnight interest rate on interbank loans of deposits those banks hold with the U.S. Federal Reserve. Because this interest rate is quite sensitive to the total quantity of these deposits that the Fed allows, the Fed can set a fairly precise target for the federal funds rate. The actual fed funds rate on any given day is determined by the supply and demand of the lent funds for that day, but the market rate usually ends up pretty close to the Fed’s target.
The Federal Reserve Open Market Committee reviews its target at meetings held about every 6 weeks. The FOMC has chosen to raise this rate another 25 basis points at each of its previous 17 meetings, bringing the target to its present value of 5.25%. The big question over the last month has been whether the Fed would opt for yet another hike at next Tuesday’s meeting.
The Chicago Board of Trade offers a futures contract whose payoff is based on the average value for the effective fed funds rate over all of the calendar days of a specified month. The price of the contract implies a particular value (such as 5.35%) for what that month’s average fed funds rate might turn out to be. If the actual value turns out to be less than this (say, 5.25%), the seller of the contract will have to compensate the buyer for the difference (paying $41.67 per basis point in the standard contract).
|Date||Change in |
|Nov 6, 2002||-0.50||1.25||-0.155|
|Jun 25, 2003||-0.25||1.0||+0.025|
|Jun 30, 2004||+0.25||1.25||+0.005|
|Aug 10, 2004||+0.25||1.5||+0.015|
|Sep 21, 2004||+0.25||1.75||+0.005|
|Nov 10, 2004||+0.25||2.0||0.000|
|Dec 14, 2004||+0.25||2.25||0.000|
|Feb 2, 2005||+0.25||2.5||0.000|
|Mar 22, 2005||+0.25||2.75||0.000|
|May 3, 2005||+0.25||3.0||0.000|
|Jun 30, 2005||+0.25||3.25||0.000|
|Aug 9, 2005||+0.25||3.5||0.000|
|Sep 20, 2005||+0.25||3.75||+0.005|
|Nov 1, 2005||+0.25||4.0||0.000|
|Dec 13, 2005||+0.25||4.25||0.000|
|Jan 31, 2006||+0.25||4.5||0.000|
|Mar 28, 2006||+0.25||4.75||0.000|
|May 10, 2006||+0.25||5.0||-0.005|
|Jun 29, 2006||+0.25||5.25||-0.005|
The rest of us can look at the interest rates specified in the futures contracts for a quick summary of what participants in the market are expecting the Fed to do next. Historically, the fed funds futures prices have done a pretty good job of anticipating. Since 1994, the average absolute value of the difference between the futures price as of the end of the previous month and what the actual average for that month turns out to be has been 5 basis points. The prediction 2 months ahead has a mean absolute error of 9 basis points, and 3 months ahead 15 basis points. One standard of comparison that is often hard to beat with financial data is the no-change forecast. The average squared forecast error from a no-change forecast is about 3 times as big as the squared error implied by futures prices for the 1, 2, or 3-month horizons.
In the more recent past, the quality of the fed funds futures predictions has gotten even better. The average one-month-ahead absolute forecast error since 2003 was well below 2 basis points. By the day before any recent FOMC meeting, the market basically had the outcome nailed. The change in the price of the current-month futures contract on the day of each of the last 14 FOMC meetings has been less than a single basis point, and by far the most common outcome is for there to be literally zero change on the day of an FOMC meeting. In recent years, the market has thus had essentially no doubt as to the outcome of any meeting.
In contrast to this boring predictability, the current month has finally brought some real excitement for Fed watchers. If the Fed does raise the target on August 8, that would justify an August futures price of 5.44% = (8/31) X 5.25 + (23/31) x 5.50, whereas if it doesn’t change, the correct value would be 5.25%. For most of July, the August contract traded right smack in the middle of those two possibilities. During the past few weeks, evidence mounted that inflation has crept up (see for example Tim Duy,
Mark Thoma, William Polley and Dave Altig), lending credence to those who advocated another rate hike. But the news of further deterioration on the real side has been equally depressing (see for example
Brad DeLong, and
Nouriel Roubini), arguing for a pause. Bad news from both sides seemed to keep the futures price balanced in the middle.
But the pause camp received some powerful new ammunition with today’s employment report from the Bureau of Labor Statistics. This showed only 113,000 new jobs added in July, whereas 150,000 or so are usually needed to keep up with the growing number of job-seekers. The result was that the unemployment rate jumped from 4.6% to 4.8%. I also pay attention to the household survey of employment. This was even more disappointing, showing no growth at all but rather a decline of 34,000 people fewer employed in July.
In any case, the BLS release seems to have settled the argument, as least as far as the CBOT Fed watchers are concerned. The August contract has fallen 5 basis points as of this morning on the release of the BLS statistics. For comparison, the biggest single one-day change in the current-month futures contract going back to January 2002 was 3 basis points. As news goes, the market treated today’s report as quite a bombshell.
And I must say that conclusion works for me. Yes, inflation is a real concern, meaning rate hikes at subsequent meetings remain a possibility. And inflation worries will doubtless prevent the Fed from lowering rates back down to the degree that a deteriorating economic outlook might otherwise warrant. But inflation is a longer run risk that cannot be solved with short-run monetary policy. I see the current game plan for the Fed to be to try to engineer as much of a slowdown as possible without causing a recession.
And I agree with the market that 5.25% may be about as far as we dare go at the moment.