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Trust Economists, But Verify

When Forecasting Fed Moves, Check with Those Putting Money on Their Views

By: William Hester, CFA
November 2003
All rights reserved and actively enforced.

When will the Fed begin to raise interest rates? Depends on whether you ask economists or investors. Interestingly, these two groups are beginning to have a widening gap between their forecasts. Knowing the opinions of both groups will help you figure out when the Fed may make its first move.

In the announcement following this month's policy meeting, the Fed stuck mainly to its script, saying that spending is firming, the labor market is stabilizing, and prices remain muted. Back for its third appearance in as many meetings, and sure to give Fed Watchers something to ponder for the next few weeks, was the remark that easy money would be around for a ‘considerable period'.

The Fed hasn't quantified what a considerable period is, but the phrase was clear enough to 57 economists polled by Bloomberg last week, who concluded that the Central Bank is on hold until next year. A majority thinks the first rate increases will not come until the third quarter of next year.

Some investors disagree, though, and think the Fed will be forced to raise overnight rates in March of next year, or even January. As recent economic growth has surprised some investors, they are becoming more certain of this forecast. You can see this best by looking at the price of the Fed Funds futures contracts.

The Fed's Future

A futures contract is an agreement to buy or sell an asset at a specific price at some future date. The contracts on the Fed funds rate – the rate at which banks lend to one another to meet reserve requirements – are priced to imply a particular interest rate. This implied yield can be found by subtracting the contract's price from 100 (for example, a price of 99 would imply a rate of 1 percent). The price rises on expectations of lower rates and falls on forecasts for higher rates.

Like all futures contracts, hedgers and speculators create the market for the Fed funds rate. Hedgers try to immunize themselves against a future change in the rate. For instance, a bank that is a frequent lender at the Fed funds rate, and wants to protect against a drop in the rate, would buy contracts. If interest rates fell, the bank's lower lending income would be offset by a gain in the price of the futures contract. Speculators, on the other hand, hope to profit from a particular outcome. Both parties keep the near-term contracts fairly liquid.

The “implied yield” on a contract is what traders expect the Fed funds rate to average over the contract's expiration month. By comparing this rate with what the month's average Fed funds rate will be if a change actually takes place, you can figure out the probability the market is placing on a potential change in interest rates.

To make the calculation back-of-the-envelope friendly, we'll assume the Fed will raise rates by 25 basis points at a time and only on the day of a scheduled FOMC meeting. Considering the current tenuous economic rebound, these are fair assumptions.

And the Probability Is…

First look up the month and the day of the next FOMC meeting (find this on the Federal Reserve's website at http://www.federalreserve.gov/FOMC/ ) The next and last meeting of this year is on December 9.

Currently the Fed funds target rate is 1 percent. The next FOMC meeting is midday on the ninth of December – 9.5 days into the month and 21.5 days before the end of the month. If you assume the Fed increases the target rate from 1 percent to 1.25 percent at that point, the average effective rate for the month of December will be:

[(9.5)(1.00)+(21.5)(1.25)]/31= 1.17

In other words, if for the first 9.5 days of the month there is a 1.00 percent rate, and for the remainder of the month it is 1.25 percent, the average rate for the month would be 1.17 percent.

Now look up the implied yield on December's contract (these yields can be found in Barron's each weekend.) Last week, the December contract was priced at 98.99, for an implied yield of 1.01.

Next we need to figure out how fully investors are pricing in a potential change. December's implied yield of 1.01 percent is only 6 percent of the way from the current Fed funds target of 1.00 percent toward the average effective rate of 1.17 percent.

(1.01-1.00)/(1.17-1.00) = .06

So investors are betting that there is only a 6 percent chance that the Fed will increase interest rates next month. On this basis, it seems unlikely that rates will change for the remainder of this year.

But looking into early next year, investors think differently. The contracts place a 50 percent probability on an increase at the January policy meeting. By March, a full 25 basis point increase is already priced in. According to the recent Bloomberg survey, only 8 of the 57 economists would agree.

A March tightening isn't a sure thing, of course. Futures traders have no better information than economists do. Both will change their outlooks as new data arrives. And the longer the time frame, the less effective a forecast will be.

But next year as each FOMC meeting grows near, keep your eye on this calculation. A contract's accuracy improves as a policy meeting approaches. This is because Alan Greenspan and other members frequently signal their intentions to change interest rates, and the prices of the Fed funds futures are sensitive to his outlook. About a week before the meeting, the contract's price is usually very clear in its forecast.

Thanks to Jim Bianco of Bianco Research and Dana Saporta of Stone and McCarthy Research Associates for helpful conversations.


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