Saturday, November 1, 2008

Where is the Fed funds rate headed?

As expected, the Fed slashed its policy rate by 50bp this week. With the Federal funds rate already at 1%, the question is how further could it go down. Federal Reserve Bank of San Francisco President Janet Yellen recently said that it could definitely go lower. Having taking the necessary cues, many people have been concluding from a Taylor rule that rates could go to nilch.

One important question to ask is what the markets are thinking. The most obvious way to answer this question is to look at the bunch of surveys of market participants and economists that Reuters, Bloomberg and others conduct.

For an even more market-oriented approach, we could look at derivatives based on the policy rate. One is the overnight indexed swap (OIS), which -for the US- is based on a geometric average of the effective fed funds rate (for a detailed explanation, see this). One issue with the OIS is that as Rebecca Wilder explains in an a well-written post, effective funds rate has been lower than the policy rate for some time, so while an accurate measure in normal times, it is likely to encompass a downward bias in present times.

We could also look at futures and options of the Fed funds rate. For technical reasons (a recent Federal Reserve Bank of Cleveland paper explains what I mean), options are more reliable than futures for this purpose, and once you can get make some assumptions, you can work your way from options prices to Fed funds rate probabilities. While, you can get the probabilities based on options and futures on Bloomberg, you do not know what their assumptions are. Luckily, Cleveland Fed has an excellent web site that goes over all the methodological issues in addition to publishing the daily probabilities based on options.

But whatever method you are using, you are getting at least another 25bp cut before year-end...

Small addendum on Turkey:

I plan to make a more complete piece for the Turkish policy rates in the near future, but suffice it to say that both the Central Bank and news channel CNBC-E conduct surveys of market participants on the policy rate. Whereas CNBC-E focuses on the upcoming MPC meeting, the CBT also collects expectations on 3 and 12 month-ahead policy rates.

While we do not have instruments derived from the policy rate in Turkey, we can deduct the expected policy rate from cross currency swaps, which I will detail in an upcoming post.

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