Probability that The Fed Will Cut Rates Again on October 31 Now At 84%

Last week's aggressive rate cut by the Fed, which knocked the U.S. Prime Rate down from 8.25% to the current 7.75%, has left everyone asking the big question: will the Federal Open Market Committee (FOMC) cut short-term interest rates again when they next decide on rates on October 31? Right now, the fed funds futures market is 84% certain that the Fed will cut rates again, by 25 basis points (0.25 percentage point) this time.

But does the U.S. economy really need another rate cut? Of course, no one knows for sure, as monetary policy is hardly an exact science, but we'll have a much better idea of how the economy is doing when the next jobs report is released by the Labor Department on October 5.

So far this week, the news has been pretty gloomy:

• Yesterday, the National Association of Realtors® reported that sales of existing (preowned) homes fell by 4.3% last month. Right now, there are more than 4.5 million used homes available on the market, which is 10 months supply. This, of course, is bad news for homeowners looking to sell, because it puts downward pressure on prices.
  
• Earlier today the Commerce Department reported that new orders for manufactured durable goods fell by 4.9% last month (economists were expecting a decline of about 3.1%.)

The Latest Odds

As of right now, the investors who trade in fed funds futures have odds at 84% (according to current pricing on contracts) that the Federal Open Market Committee (FOMC) of the Federal Reserve will vote to lower the benchmark Federal Funds Target Rate by 25 basis points at the October 31^ST, 2007 monetary policy meeting.


Summary of the Latest Prime Rate Forecast:

• Current odds that the Prime Rate will be cut to 7.5% after the October 31^ST, 2007 FOMC monetary policy meeting: 84% (likely)
  
• NB: U.S. Prime Rate = (The Federal Funds Target Rate + 3)

The odds related to federal-funds futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned for the latest odds. Odds may experience a significant shift on the release of the following economic report:

• Friday, October 5, 2007: The Labor Department releases the Employment Situation report for September.

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U.S. Prime Rate Is Now 7.75%

Ladies and gents: the cost of borrowing just got cheaper. In accordance with the latest forecast, the Federal Open Market Committee (FOMC) of The Federal Reserve has just lowered its target for the benchmark Federal Funds Rate by 50 basis points (0.50 percentage point) to 4.75%. Therefore, as of this afternoon, the U.S. Prime Rate is now 7.75%. Many American banks have already issued a press release announcing that their prime lending rate has been lowered from 8.25% to 7.75%, including:

• The Bank of America*
• Wells Fargo*
• KeyCorp*
• Wachovia*

Here's a clip from a press release issued by the Fed moments ago:

"The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric Rosengren; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 5-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, St. Louis, Minneapolis, Kansas City, and San Francisco"

Today's 50 basis point cut comes as a surprise to many, as a 25 basis point cut would have been more prudent in the eyes of many economists. As noted in the above FOMC statement, the group is still worried about inflation, and crude for future delivery is right now trading at record highs ($81.51 per barrel.) Nevertheless, there was consensus among voting members of the FOMC today: the vote for a 0.50 percentage point cut was unanimous.

Wall Street is happy with today's move: right now, the Dow Jones Industrial Average (DJIA) is up by more than 289 points on the day. If you have a variable rate credit card, or a variable-rate loan tied to the Prime Rate, then you have reason to smile as well, as you can expect your interest rate to come down soon.

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Prime Rate Is Set to Drop to Either 8.0% or to 7.75%

The Federal Open Market Committee (FOMC) will release it's decision on interest rates later today (~2:15 p.m. Eastern Time) and, as of right now, the futures market is pricing 50% odds of a 25 basis point cut, and 50% odds of a 50 basis point reduction for the Fed Funds Target Rate. In other words, the market is certain that the Prime Rate will be cut today, but it's not sure whether the cut will be to 8.0% or to 7.75% (the current U.S. Prime Rate is 8.25%.)

I'm sticking with my prediction that the Fed will opt for a 25 basis point (0.25 percentage point) cut later today. The Fed doesn't want to cut too aggressively now and possibly cause inflation problems down the road, in my opinion. If the FOMC cuts too aggressively now, and prices inflate at too high a pace later, then the FOMC may have to raise short-term rates beyond their current levels in the future, and higher rates would in turn restrain economic growth.

Furthermore, crude oil for future delivery is right now trading at $80.72 per barrel in New York -- record highs -- and high crude oil prices could easily turn up the flames of inflation. Crude could go as high as $100 per barrel before hurricane season ends. We now live in an era of "popup hurricanes," hurricanes that can develop almost instantaneously near the shores of the Gulf of Mexico. FYI: The Atlantic hurricane season last from June 1 to November 30.


The Latest Odds

As of right now, the investors who trade in fed funds futures have odds at 100% (according to current pricing on contracts) that the Federal Open Market Committee (FOMC) of the Federal Reserve will elect to lower the benchmark Federal Funds Target Rate by at least 25 basis points at the September 18^TH, 2007 monetary policy meeting (later today.)


Summary of the Latest Prime Rate Forecast:

• Current odds that the Prime Rate will be cut by at least 0.25 percentage point after the September 18^TH, 2007 FOMC monetary policy meeting: 100% (certain)
  
• NB: U.S. Prime Rate = (The Federal Funds Target Rate + 3).

The odds related to federal-funds futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned for the latest odds.

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Decline In Non-Farm Payrolls Virtually Guarantees A Rate Cut for September 18

Investors on Wall Street expect the Fed to lower short-term interest rates on September 18. But the Fed isn't going to lower rates just because Wall Street wants it to.

The Fed is not going to lower short-term rates in response to the current credit crunch happening in the financial markets. Furthermore, the Fed is not going to lower rates in order to help the struggling housing sector.

The Fed, however, will lower rates if one or more of the major macroeconomic numbers, like employment or GDP, warrant a rate cut. Earlier this morning, the Labor Department delivered those numbers.

According to the Department of Labor, the American workforce lost 4,000 jobs last month, the first month-to-month decline in non-farm payrolls since the summer of 2003. The numbers in the August jobs report are very significant for the Fed, because the group can now lower short-term interest rates (rationale: a preemptive strike against recession) without having to worry about being accused of caving in to what Wall Street wants.

Right now, the fed funds futures market is 76% certain that the Fed will cut the benchmark Fed Funds Target Rate by 50 basis points on September 18, with 24% betting that the Fed will opt for a 25 basis point cut. In other words, the market is 100% sure that the U.S. Prime Rate will be cut by at least 0.25 percentage point on September 18 (the current U.S. Prime Rate is 8.25%.)

I'm thinking that the Fed will lower rates by 25 basis points on September 18, then possibly lower rates by another 25 basis points on October 31. I don't think the Fed is going to cut rates aggressively, i.e. by 50 basis points in one shot, while the broader economy is still quite strong, and risk stoking the flames of inflation. Yes, the news that non-farm payrolls declined last month wasn't positive, but the unemployment rate held steady at a reasonably healthy 4.6%. And remember, the cost of crude oil can have a significant impact on inflation, and crude for future delivery finished the week at $76.70 per barrel (crude was at $66.25 at this time last year.)

The Latest Odds

As of right now, the investors who trade in fed funds futures have odds at 100% (according to current pricing on contracts) that the Federal Open Market Committee (FOMC) of the Federal Reserve will elect to lower the benchmark Federal Funds Target Rate by at least 25 basis points at the September 18^TH, 2007 monetary policy meeting.


Summary of the Latest Prime Rate Forecast:

• Current odds that the Prime Rate will be cut by at least 0.25 percentage point after the September 18^TH, 2007 FOMC monetary policy meeting: 100% (certain)
  
• NB: U.S. Prime Rate = (The Federal Funds Target Rate + 3)

The odds related to federal-funds futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned for the latest odds.

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