Monday, July 03, 2006

Fed at 5.25% or 5.50% in August? Probably 5.25%

Fed funds futures currently "forecast" a reasonably high probability that the Fed funds target interest rate will by 5.50% after the August 8, 2006 FOMC meeting. As usual, we have to be careful with the last hike forecast by fed funds futures since some number of market participants are buying into it as an insurance hedge on their other investments rather than an outright bet that that is what the Fed will really do. Nonetheless, that is where the futures market is today.

I still lean towards the Fed not hiking in August as I expect that inflationary pressures and economic strength will moderate enough over the coming month to lead the Fed to believe that the the lowest risk path is to "pause" at least temporarily to allow past hikes to finish rippling through the economy.

That said, there is a good chance that inflationary pressures may remain robust over the coming month, in which case the markets and the Fed will likely be persuaded that yet another quarter-point hike (to 5.50%) is the least-risk path.

In summary, any Fed action or inaction in August is certainly not preordained, but critically dependent on "incoming data", including official economic reports, private economic reports, anecdotal reports from the regional Fed banks (e.g., the Beige book), commentary by businesses on their sales and investments, and computer forecasting models as well. And ultimately it will be a purely seat-of-the-pants call by the FOMC and the Fed chairman themselves.

In truth, a quarter-point one way or the other has negligible impact on the overall health or direction of the economy. Sure, it may have actual effects, but people will adjust and reallocate capital to compensate for it. Besides, there is so much cash sloshing around in the coffers of big companies, that the Fed is not as relevant as it once was.

-- Jack Krupansky


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