Economic Research and Data

Economic Trends

Filling you in on the current state of the economy

01.04.07

Market Expectations of Policy Rates

by Bruce Champ and Bethany Tinlin

 

On December 12, the Federal Open Market Committee (FOMC) decided to leave the federal funds rate unchanged at 5.25 percent. In its statement, the FOMC noted that economic growth had slowed, primarily because of a weak housing market. However, the committee also remarked that “the economy seems likely to expand at a moderate pace on balance over coming quarters.” The FOMC expressed some concern about recent data on core inflation but felt that “inflation pressures seem likely to moderate over time.” It left open the possibility of additional policy tightening in order to curb potential “inflation risks.” Richmond Fed President Jeffrey M. Lacker dissented from the committee’s decision, preferring a rate hike of 25 basis points.

 

Reserve Market Rates

a. Weekly average of daily figures.
b. Daily observations.
Source: Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15.

 

Looking ahead, participants in the federal funds options market currently expect the FOMC to keep the funds rate at 5.25 percent over the next two meetings. These expectations were moderately reinforced by the December 12 decision. Key data releases, such as revisions in third-quarter GDP and data on home sales, had only minor impact on expectations regarding the future course of monetary policy. The minutes of the December meeting, released on January 3, seemed to jar recent investor optimism. Market participants focused on the extent of the FOMC’s concern regarding the housing market slowdown, and the minutes’ release prompted a sharp decline in the stock market. However, the release of the minutes had little impact on expectations regarding future monetary policy.

 

Currently, participants place more than a 95 percent probability on the committee keeping the funds rate at 5.25 percent at the January meeting. Looking further ahead toward the FOMC’s March meeting, participants overwhelmingly expect no change in policy, although a 13 percent probability is placed on a cut of 25 basis points in the funds rate at that meeting. Participants in the federal funds futures markets also see the possibility of a policy reversal in March.

 

Implied Probabilities of Alternative Target Federal Funds Rates, January Meeting Outcome*

 

*Probabilities are calculated using trading-day closing prices from options on January 2007 federal funds futures that trade on the Chicago Board of Trade.
Sources: Chicago Board of Trade; and Bloomberg Financial Services.

 

Implied Probabilities of Alternative Target Federal Funds Rates, March Meeting Outcome*

*Probabilities are calculated using trading-day closing prices from options on March 2007 federal funds futures that trade on the Chicago Board of Trade.
Sources: Chicago Board of Trade; and Bloomberg Financial Services.

 

Implied Yields on Federal Funds Futures*

*All yields are from constant-maturity series.
a. One day after FOMC meeting.
Source: Bloomberg Financial Information Services.

 

Eurodollar futures, which provide a longer-run perspective on the expected course of monetary policy, similarly point policy change over the coming months. Participants in this market expect the FOMC to lower rates throughout 2007; however, they also expect a fairly quick round of policy easing, with rate hikes in 2008.

 

Implied Yields on Eurodollar Futures

a. One day after FOMC meeting.
Source: Bloomberg Financial Information Services.

 

During the last round of policy tightening, from June 2004 to June 2006, the real federal funds rate, defined as the effective nominal federal funds rate less core PCE inflation, rose more than 370 basis points. Currently, the nominal funds rate stands near the upper end of the range suggested by the Taylor rule, with a target inflation rate of between one and three percent. The Taylor rule views the federal funds rate as a reaction to a weighted average of inflation, target inflation, and economic growth.

 

Real Federal Funds Rate*

*Defined as the effective federal funds rate deflated by the core PCE. Shaded bars represent periods of recession.
Sources: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15; Federal Reserve Bank of Philadelphia; and Bloomberg Financial Information Services.

 

Taylor Rule*

 

*The formula for the implied funds rate is taken from the Federal Reserve Bank of St. Louis, Monetary Trends, January 2002, which is adapted from John B. Taylor, “Discretion versus Policy Rules in Practice,” Carnegie–Rochester Conference Series on Public Policy, vol. 39 (1993), pp. 195214.
a. This line assumes an interest rate of 2.5 percent and an inflation target of 1 percent.
b. This line assumes an interest rate of 1.5 percent and an inflation target of 3 percent.
Sources: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15; Federal Reserve Bank of Philadelphia; and Bloomberg Financial Information Services.

Economic Trends is published by the Research Department of the Federal Reserve Bank of Cleveland. Views stated in Economic Trends are those of individuals in the Research Department and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System.




Economic Trends is published by the Research Department of the Federal Reserve Bank of Cleveland.

Views stated in Economic Trends are those of individuals in the Research Department and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Materials may be reprinted provided that the source is credited.

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