Fed-watching can be something of an arcane sport. Will the subtle disappointments in the May employment and automobile sales figures persuade the Fed to hold back on another interest rate hike? And what would someone who’s really “in the know” infer from how high Alan Greenspan raised his right eyebrow at his last public appearance? Although playing that game can be fun, it’s actually quite easy for anybody to have a very well-informed belief about what we can expect next from the Federal Reserve.

A good starting point is the observation that the Fed has a very strong aversion to being perceived as waffling back and forth between different stances. They’ve changed the target for the fed funds rate (the key interest rate that monetary policy controls) a total of 60 times since November of 1989. On 53 out of those 60 occasions, the Fed made a change in the same direction as it had in the previous target change. In other words, 88% of the time, if the Fed is going to make a change, it will just repeat what it did before.

On the 7 occasions when the Fed did change direction, on average it took about a year before changing its course. For example, the Fed was continually lowering interest rates from January 2001 until June 2003, but kept interest rates steady at 1% before beginning the current tightening phase in June 2004.

Given that the Fed’s most recent move on May 3 was to raise the target, what this means is that if you simply predicted that the next time that the Fed changes interest rates, the move will be up rather than down, 9 out of 10 times you’d be right. Making the right call 9 out of 10 times is a pretty darn good track record for even the fanciest, most expensive forecasting model to try to beat

But if you really want to use the fanciest, most expensive forecasting model anyway, my advice is to go ahead, but let somebody else pay for it. Let the people who’ve made those investments express their views in terms of where they’re willing to wager substantial sums of money to back up their judgments, and let the market figure out the consensus of those opinions through supply and demand. This is the basic idea behind a research paper by John Carlson and Ben Craig at the Federal Reserve Bank of Cleveland and William Melick at Kenyon College. Their idea is to use the prices people are willing to pay for fed funds futures options to infer the consensus about what the market believes that the Fed is going to do next.

One can purchase a contract on the Chicago Board of Trade that will pay the difference between 3.25 and the average fed funds rate during the month of July, if that difference is positive, but pay nothing if the difference is negative. (This is the “at the money” put option with strike price of 96.75). So, if the Fed decides at its meeting at the end of June not to raise its target for the fed funds rate above its current value of 3.00, you’d make 0.25, or, with 30 days of interest on a contract of $5 million, a cool $1,040 profit from the deal.

So how much are investors willing to pay for this contract right now? The current price is about 0.013. Why so low? The answer is, investors judge the probability of this event– that the Fed does not raise the target– to be quite low. The amount they’re willing to pay for the contract is consistent with the belief that there is only about a 5% probability that the Fed doesn’t raise the target ((0.05) x (0.25) = 0.0125).

There are in fact several different call and put options with different strike prices that traders can buy, and one can find probabilities that best characterize this set of prices, adding some other refinements to these calculations not worth troubling the dear reader with here. The point is, you don’t have to do these calculations yourself, in fact, you don’t even have to understand the explanation above. David Altig’s macroblog provides the wonderful service of reporting the probabilities implied by current option prices. The graph below is an example of what he treats his readers to each week.

Source:
macroblog

This graph reports not only where the probabilities are at the moment (the final entry on the graph, put together from Monday’s options prices), but also what these implied probabilities were when these July options were traded back as early as February. The graph indicates that back in February, investors were assigning a 45% probability that the Fed’s July target would be 3.25, a 40% probability that it would be 3.0, and a 15% probability that it would be 3.5. As the months progressed, traders have become increasingly convinced that we’ll see a target of 3.25, in other words, that the Fed will raise the target by 25 basis points at the end of this month.

So now you know what it means when you see this or that expression on Alan Greenspan’s face– it means interest rates are headed up.