Economist's Commentary: March 19, 2008
After the FOMC Meeting: What Does the Market Say?
By Danielle Hale, Research Economist
The Fed surprised the market by cutting slightly less than the market-expected 100 basis points in the Fed funds rate. Right after the move, the stock market quickly retreated. However, by the end of the day, the stock market made a strong comeback. This movement suggests that the market is "quietly" pleased with a 75 basis point cut as the Fed is reasserting its inflation-fighting credentials and perhaps signaling that the worst in the credit crisis may be coming to an end.
In order to understand the market's reaction to the change in the Fed funds rate on Tuesday, March 18, 2008, it makes sense to first examine what the market was thinking before the Federal Open Market Committee (FOMC) Meeting. Fortunately, the Federal Reserve Bank of Cleveland maintains a very useful Federal Funds rate forecast based on the prices of future options contracts. Using these contract prices, we can infer the probability of different policy outcomes.
As you can see in the chart, the expectations of participants in this market have fluctuated widely over the last month and a half. In late January, before the last scheduled FOMC meeting (January 29/30) and just after the unscheduled meeting on January 22 when the FOMC surprised markets with a reduction in the Fed funds rate from 4.25% to 3.5%, the market placed a probability of almost 50% on a 2.75% Fed funds rate after the meeting in March. When the FOMC lowered the rate again the following week to 3.0%, the implied probability of a 2.75% rate quickly fell and the probability of a 2.5% rate shot up to just over 40%.
After the release of the January meeting minutes and Consumer Price Index data on February 20, the implied probability of a 2.5% Fed funds rate climbed and continued to do so through the release of Existing Home Sales, Producer Price Index, and a few other housing-related data releases. The implied likelihood reached a peak of almost 75% before falling. Thursday's numbers placed about equal weight of an outcome of 2.5% or 2.25%, but by Friday the implied probability was more equally distributed between 2.0% and 2.25%.
After the Fed approved a reduction in the discount rate by 25 basis points to 3.25% on Sunday, the Monday market put slightly more than 40% probability of a 2.0% Fed funds rate with just under 20% probability that the outcome would be a 2.25% rate. Throughout the course of trading on Tuesday that disparity increased until the announcement at 2:15 p.m.
When the Federal Reserve announced that it would lower the Fed funds rate by 75 basis points to 2.25%, the market was surprised. In the statement that accompanied the announcement, the committee noted, "Today's policy action, combined with those taken earlier… should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability." The document contained other language that further suggests that the Fed is attuned to those on both sides clamoring for opposite courses of action. The Fed's willingness to slightly disappoint the market should be somewhat reassuring to those who are worried about its inflation-fighting credentials, yet the Fed's continued reduction of the Fed funds rate and simultaneous additional reduction in the discount rate demonstrate that the Fed is still focused on economic growth.
Minutes from today's meeting should be available on April 8. Federal Reserve watchers and market participants will dissect these minutes for more insight on the meeting discussion, especially on the concerns of President Richard W. Fisher of Dallas and President Charles I. Plosser of Philadelphia who dissented today, preferring "less aggressive action." This information will eventually filter into markets ahead of the FOMC's scheduled April 29/30 meeting as participants again try to anticipate Fed policy and adjust contracts accordingly. This policy adjustment is likely to keep mortgage rates steady and may even bring down mortgage rates if inflation expectations remain contained.
This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >
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