Let’s investigate Fed Fund Futures and rate cut expectations.
The above chart is adapted from May and June CME Fedwatch Futures.
The next Fed meeting is on May 7. As of March 23, the market thinks there is only a 22.1 percent chance of a single quarter-point cut.
But if we further out to the following FOMC meeting on June 18, rate cut odds jump to a combined 77.9 percent for at least one quarter-point cut.
September CME Fedwatch
September CME Fedwatch Synopsis
- No Cut: 4.1 Percent
- One Cut: 24.0 Percent
- Two Cuts: 43.2 Percent
- Three Cuts: 25.5 Percent
- Four Cuts: 3.2 Percent
- At Least Two Cuts: 71.9 Percent
- Three or Four Cuts: 28.7 Percent
Weighted Average Expectation
The weighted average expectation is 3.876 percent. That’s smack in the middle of the two rate cut range of 3.75 to 4.00 percent.
Fed Holds Key Interest Rate Steady
On march 19, I reported The Fed Ups its Inflation Forecast, Holds Key Interest Rate Steady
Summary of Economic Projections: GDP lower, Inflation higher, Unemployment rate higher.
Dot Plot
The weighted average of the Summary of Economic Projections (SEP) Dot Plot is 4.007.
That’s 0.131 percentage points higher (about an eight of a point ) than CME Fedwatch, roughly 1.5 cuts instead of two.
And it’s through December, not September. Through December, the market expects one more quarter-point cut than the Fed.
Is Market Driving Rate Cuts?
No, not really. The Fed jawbones the market with nonsense about inflation expectations, dot plots, and forward guidance.
The market tends to front-run Fed jawboning.
But when the market gets too far in front or behind what the Fed wants to do, a parade of Fed governors starts yapping, generally in-line with what the Fed Chair wants to do.
The Fed Uncertainty Principle
Please consider The Fed Uncertainty Principle written April 3, 2008 before the collapse of Lehman Brothers and Bear Stearns.
Does the Fed Follows the Market?
Most think the Fed follows market expectations.
However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? More pointedly, why isn’t the market to blame if the Fed is simply following market expectations?
This is a very interesting theoretical question. While it’s true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.
If market participants expect the Fed to cut rates when economic stress occurs, they will take positions based on those expectations. These expectation cycles can be self-reinforcing.
The Observer Affects The Observed
The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg’s Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.
The Fed, by its very existence, alters the economic horizon. Compounding the problem are all the eyes on the Fed attempting to game the system.
A good example of this is the 1% Fed Funds Rate in 2003-2004. It is highly doubtful the market on its own accord would have reduced interest rates to 1% or held them there for long if it did.
What happened in 2002-2004 was an observer/participant feedback loop that continued even after the recession had ended. The Fed held rates rates too low too long. This spawned the biggest housing bubble in history. The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.
In a free market it would be highly unlikely to get a yield curve that is as steep as the one in 2003 or as steep as it was just weeks ago when short term treasuries traded down to .21%.
The Fed has so distorted the economic picture by its very existence that it is fatally flawed logic to suggest the Fed is simply following the market therefore the market is to blame. There would not be a Fed in a free market, and by implication there would be no observer/participant feedback loop.
In my post, I provided four key corollaries with discussion. Here is a short synopsis condensed from the full post.
Fed Uncertainty Principle: The fed, by its very existence, has completely distorted the market via self-reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication, there would not be observer/participant feedback loops either.
Corollary Number One: The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.
Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.
Corollary Number Three: Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.
Corollary Number Four: The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.
The Fed Uncertainty Principle is still my all-time favorite post.
Related Posts
On October 21, 2021 I commented A Fed Economist Concludes the Widely Believed Inflations Expectations Theory is Nonsense.
The research department had these two amusing quotes in its report.
- It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought. John Kenneth Galbraith (1958).
- Few things are harder to put up with than the annoyance of a good example. Mark Twain, The Tragedy of Pudd’nhead Wilson (1894)
December 24, 2024: Dear Fed, Please Shut Up Already, Stop the Forward Guidance
Danielle DiMartino Booth claims the Fed should be cutting more, not less. I have a different suggestion.
Since the Fed has no idea, it should stop forward guidance that the market front runs thereby amplifying the feedback looks discussed above.
More accurately, there should not be a Fed at all. It’s proven clueless.