Saturday, August 11, 2007

Despite mortgage woes, Fed still 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 the minor financial crisis that markets went through last week, the economy really is in quite decent shape, so the Fed really does remain on track to keep the fed funds target rate paused at 5.25% for the rest of the year and probably well into 2008.

Sure, plenty of so-called "professionals" on Wall Street are clamoring for rate cuts and the fed funds futures market does indicate that people are betting on a cut within the next two months and three cuts within a year, but it is never wise to depend too heavily on "forecasts" made by people in the "heat" of a crisis.

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

  • Between now and the September 18, 2007 meeting: 60% chance of a cut -- flip a coin, but leaning towards cut
  • September 18, 2007: 98% chance of a cut -- cut is virtually a "slam dunk"
  • October 30/31, 2007: 100% chance of a cut and 38% chance of a second cut
  • December 11, 2007: 100% chance of a cut and 86% chance of a second cut -- second cut is likely
  • January 2008: 100% chance of two cuts and 34% chance of a third cut
  • March 2008: 100% chance of two cuts and 62% chance of a third cut -- flip a coin, but leaning towards third cut
  • May 2008: 100% chance of two cuts and 88% chance of a third cut -- third cut is likely
  • June 2008: 100% chance of three cuts and 2% chance of a fourth cut

So, the futures are telling us that a cut is a virtual "slam dunk" for the September meeting, but I would urge caution in depending on that number since: a) the Fed has given no indication that it is leaning towards such a cut, and b) bets placed in the "heat" of a crisis are frequently unwound in the weeks following the crisis.

Note: Studies have shown that the fed funds futures market only has a high degree of forecast reliability about 30 to 45 days out (high out to 30 days, only modest reliability out to 60), so those probabilities beyond September are shaky at best and could easily change very dramatically.

What we saw last week was a simple knee-jerk reaction to a very real, but brief crisis. Wait a few weeks and the picture will change again.

-- Jack Krupansky

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