Fed still likely to stay on track with 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 all of the "turmoil" in the financial markets and a credit crunch is some credit markets, the Fed will likely continue on its current path and stay on track to keep the fed funds target rate paused at 5.25% for the rest of the year and probably well into 2008.

Yes, the Fed did cut their "discount" rate and did issue a special inter-meeting FOMC statement that said that the FOMC is "monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets", but that is still quite a distance from actually cutting the fed funds target rate.

Yes, the Fed is poised and prepared the pull the trigger on one or more rate cuts should the economy need them, but the Fed also told us on Friday that "recent data suggest that the economy has continued to expand at a moderate pace", strongly suggesting that the Fed does not believe that any fed funds target rate cuts will be needed in the near future.

The key takeaway from the FOMC statement on Friday is that the Fed is telling everybody "We actually do have our finger on the trigger and we really are vigilant on the state of the economy, so we really are prepared to cut rates if the economy needs it, so chill."

The Fed cut only the "discount rate" on Friday. This is the interest rate that the Fed charges financial institutions to directly borrow money from the Fed. Usually, only banks in serious distress utilize the "discount window", but the current situation is such that even finanicial institutions in only modest distress might conceivably utilize the discount window.

The financial duress of the past few weeks has not been due to a lack of money in the real economy, but primarily a lack of "liquidity" in the the banking system due to the fact that a lot of banks have gotten involved in holding mortgage-based securities since they were so popular and profitable. The result was a temporary spike in interest rates driven by banking liquidity rather than a spike in real demand. By pumping liquidity into the banking system, the Fed enables normal demand to be met on more normal terms. In short, it wasn't necessary to try to lower normal rates, but simply to supply sufficient banking liquidity to enable banks to lend at normal rates.

Another key takeaway is that to date, the Fed has only been adding liquidity to the banking system and has not taken any action to stimulate the economy. I know, many of the denizens of Wall Street are howling about how the mortgage mess is going to throw the economy into a recession, but it just ain't so. Just this past Wednesday, the Fed itself issued the Industrial Production and Capacity Utilization report for the month of July and it showed a monthly production rise of 0.3% and a slight rise of 0.1% in capacity utilization. This is not an economy headed into recession. Sure, the Fed will be vigilent in the weeks and months ahead, but people are whining about a situation that simply hasn't been transpiring.

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 month and three cuts by the end of this year, but it is never wise to depend too heavily on "forecasts" made by people in the "heat" of a crisis.

Normally, the Fed funds futures prices are a reliable indicator of what the Fed will do over the next 45 days or so, but we are not in a normal market right now, so I think there is a huge "fear factor" overlaying normal demand for fed funds futures. Yes, a lot of people are "betting" on a number of Fed rate cuts and soon, but I do think it is reasonable to discount much if not all of this frenzied speculative "betting." In short, I'll give you the numbers, but I urge you to deliberate carefully before paying too much attention to them.

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

• Over the next two weeks: 88% chance of a cut -- cut is very likely
• September before the September 18, 2007 meeting: 100% chance of a cut and 26% chance of a second cut
• September 18, 2007: 100% chance of a cut and 60% chance of a second cut -- flip a coin, but leaning towards a second cut
• October 30/31, 2007: 100% chance of a second cut and 46% chance of a third cut  -- flip a coin, but leaning towards no third cut
• December 11, 2007: 100% chance of a third cut -- third cut is very likely
• January 2008: 100% chance of three cuts and 40% chance of a fourth cut
• March 2008: 100% chance of three cuts and 68% chance of a fourth cut -- flip a coin, but leaning towards a fourth cut
• May 2008: 100% chance of three cuts and 92% chance of a fourth cut -- fourth cut is likely
• June 2008: 100% chance of three cuts and 88% chance of a fourth cut
• August 2008: 100% chance of three cuts and 88% chance of a fourth cut

So, the futures are telling us that a cut is a "slam dunk" before 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 these past two weeks 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