Great Graphic: What the Market Thinks of Fed Policy

This Great Graphic is a simple table.  It is made to illustrate what the Fed funds futures strip is discounting.  

Currently the average effective rate is 1.42%.  This is an average of actual transaction in the relatively small Fed funds market, where makes trade overnight money.  It trades a little above the midpoint of the Fed’s target range, which is now 1.25% to 1.50%.    I simply add 25 bp to for each Fed hike.  

The futures column is the implied yield of the contract after the quarterly FOMC meetings.  The row labeled “First Hike 2018) says that if the Fed were to hike rates, the new average effective rate will be 1.67%.  I look at the implied yield of the April Fed funds futures contract.   The futures contract used for the fourth hike is the January 2019 contract.  

Some linked the sell-off in the US equity market yesterday to speculation that the Fed will raise rates more than the three times that the December dot plot implied.  However, the futures market does not show the market even fully discounting a third hike let alone a fourth.   

If the Fed’s dot plot next month suggests four hikes, will it matter so much if the market does not believe it?  Is it the old tree falling in the forest question?  Last year, the Fed did not try to correct the market’s misperceptions until a few weeks before the meeting, such as a year ago, and then there was a full court press.   The Powell Fed may be different.  It is the early days, but judging by his appointments of advisers, Powell is very much within the institution’s traditions.

There can be studies into different approaches to monetary policy and inflation, but ultimately, with minor tweaks, the current approach will likely remain.  That said, under Powell’s watch there will likely be an alternative target rate from the current Fed funds, which is a relatively small and unrepresentative market.  We hope the communication can change that would credibly allow rate hikes at more than four meetings a year…just in case.  


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