Saturday, September 08, 2007

Fed still likely to stay on track with target rate at 5.25% for the rest of 2007 and probably well into 2008

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 (including sporadic liquidity injections into the banking system) 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.

Despite the fact that fed funds futures prices "indicate" a 100% certainty of a rate cut at the upcoming FOMC meeting (and even before the meeting) and more cuts to come and virtual unanimity among commentaters on Wall Street in favor of cuts, there has also been a fair amount of commentary from Fed officials that "hint" strongly that not only is a rate cut not a foregone conclusion, but that cutting the fed funds target rate would be a bad idea to deal with financial market turmoil. The latest cold water on rate cuts comes from Charles Plosser, President of the Federal Reserve Bank of Philadelphia who says that "Providing liquidity does not necessarily require a more fundamental change in the direction of monetary policy as implemented by a change in the fed funds rate target." That comes from an article on Bloomberg.com on Saturday by Anthony Massucci and Vivien Lou Chen entitled "Plosser Says Rate Cut Not Always Needed to Keep Markets Stable." Another Bloomber article by Scott Lanman on Thursday entitled "Four Fed Bank Presidents Decline to Endorse Rate Cut" tells us that "Four regional Federal Reserve bank presidents declined to endorse a cut in the benchmark interest rate this month... Kansas City Fed President Thomas Hoenig and Dennis Lockhart of the Atlanta Fed said they hadn't seen sure signs of a housing spillover into the broader economy. St. Louis Fed President William Poole and the Dallas Fed's Richard Fisher said the effects of the turmoil so far are unclear." An article on Reuters by Ros Krasny entitled "Fed's Fisher: September rate cut not a done deal" quotes Dallas Fed President Richard Fisher as saying that "Market expectations come and go. The Fed's job is to get the economy right." An article in The Wall Street Journal by Sudeep Reddy entitled "Fed Sees Limited Housing Fallout" quotes Atlanta Fed President Dennis Lockhart as saying that "So far, I have not seen hard or soft data that provide conclusive signs that housing problems are spilling over into the broad economy." Finally, an article from Associated Press by Rachel Beck entitled "Likelihood of Fed Rate Cut Less Clear" informs us that "Anyone hoping that Federal Reserve policymakers will reduce the overnight bank borrowing rate when they meet on Sept. 18, should not ignore the positive signs the economy is giving."

Usually, in normal times, the fed funds futures market is a good indicator of what the Fed will do over the next month or two, but we are not in normal times right now and currently there is such a dramatic dislocation between what a lot of people fear or hope for on the one hand and what the calmer Fed is actually likely to do. So, I do report the fed funds futures here, but for now I do so with the caveat that they are completely out of whack. Yes, they do reflect what people hope and fear, but they are not predicting likely Fed activity.

In a lot of cases they are either speculative bets seeking to make a quick buck if the Fed does happen to cut rates, or actually legitimate hedges by holders of fixed income assets who are really buying insurance in case the Fed does happen to cut rates, but do not necessarily represent a core belief that the Fed really will cuts rates.

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

  • Before the September 18, 2007 meeting: 100% chance of a cut and 24% chance of a second cut
  • September 18, 2007: 100% chance of a cut and 76% chance of a second cut -- second cut is likely 
  • October 30/31, 2007: 100% chance of two cuts and 70% chance of a third cut -- third cut is likely
  • December 11, 2007: 100% chance of three cuts and 48% chance of a fourth cut -- flip a coin, but leaning away from a fourth cut
  • January 2008: 100% chance of four cuts and 16% chance of a fifth cut
  • March 2008: 100% chance of four cuts and 60% chance of a fifth cut -- flip a coin, but leaning towards a fifth cut
  • May 2008: 100% chance of four cuts and 68% chance of a fifth cut -- fifth cut is likely
  • June 2008: 100% chance of four cuts and 78% chance of a fifth cut
  • August 2008: 100% chance of four cuts and 76% chance of a fifth cut

So, the futures are telling us that a cut is a "slam dunk" before the September meeting and that a second cut at the meeting is very likely, but I would urge caution in depending on these numbers since: a) the Fed has given no indication that it is leaning towards such a cut, b) a number of Fed officials have talked down the prospects of a rate cut in the near-term, and c) 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 five weeks was a simple knee-jerk reaction to a very real, but brief crisis. Wait a few weeks and the picture will change again.

And to repeat one thing that bears repeating: the economy is much stronger than many people on Wall Street are claiming it is. "Forecasts" of the economic impact of the so-called subprime crisis are way out of proportion to the likely impact, and that is even before election politics pushes the administration and Congress to offer a substantial safety net for struggling homeowners. There is simply no economic need for a fed rate cut either now or in the near future.

-- Jack Krupansky

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