Futures Market 70% Certain Fed Will Cut Short-Term Rates by 75 Basis Points Tomorrow

The fed funds futures market is now 70% certain the Fed will cut the benchmark fed funds target rate (FFTR) by 75 basis points (0.75 percentage point) tomorrow, which basically translates to more likely than unlikely. However, this website's official forecast is the same as it was on December 5^TH: the Fed will cut the FFTR by at least 50 basis points at the December 16^TH Federal Open Market Committee (FOMC) monetary policy meeting.

Yes, it's a very safe bet that the Fed will cut its most important interest rate tomorrow. But will American banks respond by cutting their prime lending rate as usual?

Since the second quarter of 1994, American banks have pegged their prime lending rate to the FFTR. Since that time, a reliable formula for the United States Prime Rate has been:

U.S. Prime Rate = (the FFTR + 3)

On June 27, 2003, the Fed lowered the FFTR from 1.25% to 1.00%. American banks responded by lowering their prime lending rate from 4.25% to 4.00%, but some banks did so grudgingly, complaining that a 4% Prime Rate was too low for them to make a decent profit.

Tomorrow, the Fed will probably lower the FFTR from 1.00% to 0.50%, and if all goes well, American banks will respond by lowering their prime lending rate from 4.00% to 3.50%. But some large banks may resist the rate cut, opting instead to cut their Prime by 0.25 percentage point instead of 0.50, or by not cutting at all and leaving their Prime at 4.00%. This outcome is a very real possibility, as this happened just last week in Canada, the 9^TH largest economy in the world.

It's also important to note that if your bank cuts it's Prime Rate tomorrow, you may not see any change in e.g. the rate you pay on your credit card that's indexed to Prime. Many banks include an interest rate floor in credit card terms to protect themselves from deep rate cuts by the Fed. Bottom line: your credit card account may already be at your card's lowest possible interest rate as a result of the numerous rate cuts the Fed has made since September 2007. Here is an example from an Advanta business credit card agreement:

"...Your Variable Account Rate Index for any billing cycle will be chosen by us from among the Prime Rates published in The Wall Street Journal's "Money Rates" section during the three (3) months prior to the month which contains that cycle's Billing Cycle Closing Date, but will not be less than 5.00%..."

So with this particular business credit card, any U.S. Prime Rate below 5.00% is meaningless.

The good news is that some major banks like U.S. Bank, American Express and the Bank of America don't use interest rate floors with their credit cards (so far.)

Stay tuned to this blog tomorrow. We will conduct our survey, as usual, and we'll update the site as soon as we have confirmation of a rate cut by 23 of America's 30 largest bank holding companies (BHC's.) If some big banks balk, we'll let you know about that too. And please be patient, as confirmation may come very late in the day. Banks will likely be watching each other to see who moves first and by how much.

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As of right now, the investors who trade in fed funds futures at the Chicago Board of Trade have odds at 100% (as implied by current pricing on contracts) that the FOMC will vote to cut the benchmark Federal Funds Target Rate by at least 50 basis points (0.50 percentage point) at the December 16^TH, 2008 monetary policy meeting.


Summary of the Latest Prime Rate Forecast:

• Current odds that the Prime Rate will be cut by at least 50 basis points at the December 16^TH, 2008 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 constantly changing, so stay tuned for the latest odds.

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