Berson's Weekly Commentary
Economic Commentary
October 31, 2005
Another FOMC Meeting -- another tightening.
On Tuesday, the Federal Open Market Committee (FOMC, the policy making arm of the Federal Reserve) will meet to determine the course of monetary policy for the next six weeks. At each of its eleven meetings from June 2004 to the present, the FOMC has voted to raise the federal funds rate by 25 basis points. As a result, the fed funds rate has increased by 275 basis points over this time -- up to 3.75 percent. Will the FOMC continue this string of modest tightening moves? And will the policy statement change significantly and offer additional insights for future monetary policy moves? The answer to the first question is a clear yes, at least according to financial markets, while the answer to the second is probably no.
Prices on 30-day federal funds futures on the Chicago Board of Trade (CBOT) provide the market's guess as to where the federal funds rate will be at the expiration of each monthly contract (on either the 5th or the 6th of every month). This enables analysts to view the market's expectations of the FOMC's target federal funds rate for the next five meetings: November 1, December 13, January 31, March 28, and May 10. The table below shows the associated expected federal funds rate (derived from the futures prices) for each of these meeting dates (based on CBOT data as of October 27 at 5:00 PM, central daylight time). Moreover, since the Fed moves the target federal funds rate in 25 basis points increments, we can also calculate the market's assessment of the probability of a particular rate hike or cut.
Expected Federal Funds Rate
Date Rate
November 4.01%
December 4.25%
January 4.44%
March 4.59%
May 4.64%
With an expected 4.01 percent federal funds rate after the November FOMC meeting, financial markets believe there is a 100 percent probability of another 25 basis point tightening at that time. (In fact, markets see a 4 percent chance of a 50 basis point tightening at that time -- as 4.01 percent is 4 percent of the way to the next 25 basis point increment of 4.50 percent.) Financial markets also fully expect a 25 basis point tightening at the December FOMC meeting, bringing the year-end federal funds rate up to 4.25 percent.
The market's view of the odds of additional Fed tightening in the first half of 2006 go down somewhat, however. The derived 4.44 percent federal funds rate after the January FOMC meeting implies a 76 percent probability of a 25 basis point tightening at that meeting. Even if the Fed should pause at the January meeting, markets fully expect that the federal funds rate will be increased to 4.50 percent by the March FOMC meeting (in fact, the implied rate of 4.59 percent suggests that there is a 36 percent chance of a target federal funds rate of 4.75 percent after the March FOMC meeting). Finally, financial markets have placed a 56 percent probability of the federal funds rate being hiked to 4.75 percent after the May FOMC meeting.
As for the FOMC's policy statement following the meeting, markets will be looking for wording changes on the following topics: the effects of the various hurricanes on economic activity, the impact of higher energy prices on inflation (and especially any "leakage" into core inflation), the FOMC's view of whether monetary policy remains accommodative or not, and whether the term "measured pace" will continue to describe the FOMC's policy changes. We expect that any changes in the wording of the statement will reinforce the notion that the FOMC will continue to tighten monetary policy at a measured pace (25 basis points per meeting) for a while.
This will be a big week for economic data, with the key employment data for October to be released on Friday.
On Monday, personal income and spending for September are expected to recover from the prior month's decline, rising by 0.4 and 0.5 percent, respectively
Also on Monday, the Chicago Purchasing Managers Index should slip to around 58.0 in October -- which would still show strong manufacturing activity.
On Tuesday, auto and truck sales for October are expected to edge down to 12.4 million units (annualized rate) -- with consumers being cautious about buying cars and light trucks as a result of high fuel costs.
Also on Tuesday, construction spending is projected to increase by 0.5 percent in September -- with widespread gains in each of the major categories.
Additionally on Tuesday, the Institute for Supply Management's (ISM) manufacturing index should edge down to a still-strong 57.5 in October -- following September's surprising surge.
On Thursday, productivity growth for the third quarter is projected to accelerate to 2.5 percent -- based on the pickup in economic activity shown in the preliminary third quarter GDP figures.
Also on Thursday, the ISM services index is expected to rise to around 57.0 in October -- following last month's surprising decline.
Additionally on Thursday, initial unemployment claims are expected to edge down to around 325,000 for the week ending October 29th -- as the effects of Hurricane Katrina are just about over in this series.
Finally, on Friday, nonfarm payroll employment is projected to increase by 100,000 in October, with the unemployment rate, hourly earnings, and the average workweek all stable at 5.1 percent, 0.2 percent, and 33.7, respectively -- with Hurricane Katrina holding down job gains by roughly 125,000.
David W. Berson
Fannie Mae Economics
Last Revised: October 31, 2005
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