Fed on track to keep target rate at 5.25% for the rest of 2007 and probably well into 2008

[Gentle reminder: I may suspend this weekly post in the near future, but I haven't decided for sure yet.]

Despite a rather good Q2 GDP report, there is still a lot of irrational anxiety about subprime mortgage "woes" spreading "contagion" to the "real" economy. These unfounded fears have now caused people to bet on a rate cut in Q4 of this year and a second Fed rate cut in Q2 of 2008. Some people are using a lot of contrived logic to inappropriately argue that the good Q2 GDP report was really a one-off and that the economy will be heading south for the rest of the year. Sure, GDP in H2 of this year will probably average only in the 2.00% to 2.75% range, which is not great and maybe 2.25% to 3.00% in H1 of 2008, but that would absolutely not be down in the range where the Fed would even contemplate cutting interest rates. This sudden surge in negative sentiment was more of a knee-jerk reaction couple with a lot of irresponsible comments by a lot of "professionals" who should know better. I fully expect that the surge will completely unwind within the next couple of weeks as we start getting economic reports for July.

My overall assessment of Fed monetary policy remains:

The Fed will keep the target rate at 5.25% for the rest of 2007, and probably well into 2008.

There will not be a recession this year or next, nor even enough of a growth slump to trigger a Fed rate cut.

The Fed will not cut rates in response to the concern about subprime mortgages.

The Fed will not worry about the health of the economy since it is MUCH healthier than the 0.6% Q1 "real" GDP growth rate "estimate" suggested.

I would suggest that there is a 1 in 3 chance that the Fed will hike rates by a quarter-point before the end of the year.

My current feeling is that the 0.6% Q1 GDP number has frightened so many people (and emboldened so many bears and cynics) that the Fed will likely simply wait until the Q3 GDP number "prints" and demonstrates that the Q2 "recovery" is sustainable before seriously considering a rate hike.

Please note that current Fed policy at 5.25%, or even a hike to 5.50%, is not restrictive, but within the neutral range which is neither accommodative nor restrictive (approximately 4.25% to 5.75%.) All "normal" economic activities can be easily financed with Fed policy at this level. This does eliminate a lot of excessive speculative behavior, but won't crimp the average business or consumer. The odds of such a hike causing a recession are negligible.

As of Friday, Fed funds futures contracts indicate the following probabilities for changes in the Fed funds target rate at upcoming FOMC meetings:

• August 7, 2007: 20% chance of a cut -- slam dunk for no change
• September 18, 2007: 34% chance of a cut
• October 30/31, 2007: 56% chance of a cut -- flip a coin, but leaning towards a cut
• December 11, 2007: 90% chance of a cut -- cut is likely
• January 2008: 100% chance of a cut and 26% chance of a second cut
• March 2008: 100% chance of a cut and 50% chance of a cut -- flip a coin, but leaning towards a second cut
• May 2008: 100% chance of a cut and 72% chance of a second cut -- second cut is likely
• June 2008: 100% chance of a cut and 86% chance of a second cut

I personally do not agree with a any of those probabilities, but they are what the market is "saying."

The August FOMC meeting is well within the 45-day window of reliability for fed funds futures to predict Fed action, so it is a virtual "slam dunk" certainty that the Fed will not change the fed funds target rate at the August FOMC meeting. It is too soon for fed funds futures to reliably predict rates for the September or October FOMC meetings.

The futures market is forecasting a cut in Q4, but even October is too far in the future for futures to be a dependable indicator. Also, sometimes the last cut (or hike) forecast by futures is frequently an insurance hedge by vestors rather than an outright bet on the actual outcome.

-- Jack Krupansky