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Measuring Market Beliefs about the Fed Policy Rates

Since March of 2009, the Federal Open Market Committee (FOMC) has communicated that it will maintain the federal funds rate between a range of 0 to 1/4 percent and that it anticipates keeping rates within this range for an “extended period of time.” Initially, the market anticipated that rates would begin to tighten in early 2011; however, this perception no longer holds and the market now anticipates that the FOMC will continue to maintain its position of exceptionally low interest rates far out into the future.

One way of measuring the market’s expectations about changes in FOMC policy is to examine Eurodollar and fed fund futures. Eurodollar and fed funds futures represent a bet on the risk associated with short-run interest rate changes. While financial experts could be consulted, they represent only a few opinions of the market. Eurodollar and fed funds futures include many more market participants, so they better reflect the market’s perception of future interest rates. Forward rates on Eurodollar and fed funds futures are also excellent measures of the market’s perception of future rates because they are short-term rates, they represent average risk assessments, and they incorporate rough assumptions of risk aversion. Other measures that use more complicated derivatives, however, are able to show the median, mode, and other aspects of the distribution of beliefs pertaining to short-term interest rates.

The shift in the expected short rates can be explained by low inflation expectations and disappointing economic data. Currently, inflation remains low at 1.1 percent, and the Federal Reserve Bank of Cleveland’s July estimate of inflation over the next 10 years is 1.69 percent. Additionally, economic data, particularly employment, has been disappointing. As of July 2010, unemployment has held steady at 9.5 percent, and the labor participation rate has declined by 4.3 percent since the onset of the recession.

Implied Federal Funds Rate
Eurodollar Futures

The market assumes the FOMC cares about these numbers and incorporates them into their forecasts. So long as low inflation expectations and disappointing news persists, it is reasonable that the market will bet that the FOMC will maintain its current policy for the foreseeable future.

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