Tuesday, September 18, 2007

The Fed's Big Suprise

The Fed surprised many observers today by cutting the federal funds rate 50 basis points rather than the expected 25 basis points. As a result, the FT reports stock markets across the world rallied, oil futures hit record highs, and the dollar hit a record low against the Euro. The FT also reports

"...the market[s] interpreted Tuesday’s action as signalling the start of a rate-cutting cycle, pricing in a virtual certainty of a further cut at the next Fed policy meeting in October and another on or before its January policy meeting."

This is apparent in the figure below from the Cleveland Fed. Using options on fed fund rate futures, this figure shows the estimated probability of different outcomes in the October FOMC meeting. This new belief in a rate-cutting cycle is evident in the changed probability for for the FOMC moving the fed fund rate to 4.50% in October. Today the probability hit 60.2%, yesterday it was only 30.4%. That is a dramatic change in market expectations. Apparently, the markets believe they have seen a new side to the Bernanke Fed.

Update

Brian A. in the comments notes a key implication of the above developments: the Fed has made itself a slave to the markets.

2 comments:

  1. Barry Ritholtz puts it succinctly:

    "The Fed now has a third problem to deal with: They have become Wall Street's bitch. They may find that's a difficult condition to wriggle out from . . ."

    Either that, or the Fed sees some pretty scary things submerged beneath the surface.

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  2. Interesting:

    The loonie closed at 0.9864 US dollars, after touching 0.9874 US in the day's trading, its highest level since January 1977, according to the Bank of Canada.
    . . .
    In the past half decade, the loonie was highest in August 1957, at 1.0613 US, and lowest in January 2002, at 0.6202 US.

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