The options markets on federal funds futures told a pretty clear story last week. After falling off precipitously in the immediate aftermath of Katrina, the probability of 25 basis increase at next week's FOMC is the clear market guess.
From there, the picture gets fuzzier. The Carlson-Craig-Melick estimates make it about even up on the probability of either another 25 basis points or a pause (over at least one meeting):
Certainly Katrina complicated things -- and, by the looks of these pictures, had a huge impact on market expectations. In light of the weight being put on the possibility of a pause at 3.75 percent, the following picture, which appears in the most recent edition of the Federal Reserve Bank of Cleveland's Economic Trends publication, is kind of interesting:
In essence, the picture says that a central bank targeting a 1.5 percent rate of inflation (measured by the PCE price index excluding food and energy) and an output gap as estimated by the Congressional Budget Office (through the second quarter), would find the neighborhood of a 3.75 percent federal funds rate reasonably pleasing. (The upper and lower bounds in the picture correspond to 1% and 2% inflation targets, respectively.)
For the hardcore fans:
-- The estimated probabilities are calculated using the constraints described in last week's post:
Any single probability must be nonzero.
The estimates must sum to one.
The mean funds rate implied by the estimates must equal the implied rate from the futures market.
-- The market for the January contract is looking a bit thin, so I am not reporting a set of December probabilities this week. We'll keep the monitor on.
-- Here's the data:
Download implied_pdf_october_090905.xls
Download implied_pdf_november_090905.xls