Insight Line—December 10, 2007

You didn’t hear this from me, but determining how investors perceive the most probable near-term course of monetary policy from upcoming Federal Open Market Committee (FOMC) deliberations is actually no great mystery. That is, if you know where to look.

Back in 2002, researchers at the Federal Reserve Board pointed investors toward the basic data useful in constructing any near-term forecast for the potential course of monetary policy. In essence, the Fed’s researchers concluded that the federal funds futures contract¹ was, historically speaking, the preferred market-based (price) measure for investors seeking to assess investor consensus on forthcoming changes to near-term monetary policy actions.²

Over the ensuing years, other researchers within the Federal Reserve System, financial institutions and academia would follow suit, testing and retesting. Their results fell in line with those most recently attested by James D. Hamilton’s paper for the National Bureau of Economic Research, “The present study confirms that daily changes in near-term futures prices are indeed an excellent indicator of changes in market expectations of near-term Fed policy.”³ All of which I believe helps to explain why the financial media regularly references the federal funds futures market as its source for gauging consensus expectations whenever an FOMC meeting looms. And it is relatively easy for investors to do the same calculation for themselves by doing some simple math.

The most basic way to calculate the probability of a rate increase or decrease is by using the following formula with the results expressed in percentage terms:⁴

The probability of a rate increase/decrease at the next FOMC meeting =

(Implied Fed Funds Rate⁵ - Actual Fed Funds Rate) (Expected New Fed Funds Rate - Actual Fed Funds Rate)

To be sure, there is no guarantee that investors’ beliefs on the near-term direction of monetary policy and interest rates are correct—whether these views are based on an equation or otherwise. After all, the federal funds rate is a rate administered by members of the FOMC, who are not bound by a simple formula reflective of crowd consensus. Nevertheless, I believe that for those looking to gauge market-based sentiment on near-term monetary policy, the federal funds futures contract is an undeniably compelling starting point.

¹ The federal funds rate is the interest rate prevailing in the market for borrowing and lending reserve balances between Federal Reserve System member banks. The rate is directly administered by the Federal Reserve Market Trading Desk.

² Gurkaynak, Refet S., Brian Sack and Eric Swanson, “Market-Based Measures of Monetary Policy Expectations,” Working Paper Series, Board of Governors of the Federal Reserve System, August 1, 2002.

³ Hamilton, James, D., “Daily Changes in Fed Funds Futures Prices,” Working Paper 13112, National Bureau of Economic Research, May 2007, page 18 Available at http://www.nber.org/papers/w13112

⁴ For a more precise assessment, the Federal Reserve Bank of Cleveland offers an exact calculation including time value of money for exact contract delivery dates. See http://www.clevelandfed.org/research/Policy/fedfunds/index.cfm

⁵ The implied federal funds target rate is found by subtracting the currently deliverable federal funds futures contract price from 100.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.