Predicting Federal Reserve Rate Changes

Do you ever read the news or watch television and wonder what those speakers mean when they say “the market predicts the Fed will [increase rates/cut rates/do nothing]?” I have.

What they are referring to is the federal funds futures market where traders buy and sell options contracts linked to the federal funds rate. Unlike other options, where an actual asset could be delivered (an oil futures contract is actually a contract to buy or sell oil at a future date), the federal funds futures contract is a little different. Rather than butcher the definition, according to the Federal Reserve Bank of Cleveland:

A fed funds futures contract is an interest rate futures; i.e. a futures contract whose value is based on a fixed-income security or interest rate. The underlying interest rate for the fed funds futures contract is the average daily effective federal funds rate for the delivery month. The final settlement price for a contract is 100 minus this average rate.

When the market “predicts” the next Fed action, it’s really what the wisdom of the masses (the fed futures trading masses) believe, based on their trading actions, what the future federal funds rate will be in the delivery month of the option.

Where can you find this information easily? The Federal Reserve Bank of Cleveland’s Fed Funds Rate Predictions page! It’s updated daily and has tons of information (check out the excel spreadsheet you can download).

How can you use this? Outside of fun trivia, one way to take advantage of this is to avoid buying long term CDs if the prediction says the rates will go up and to buy CDs when the rates are going down. While the predictive ability spans only a few meetings in the future, it can give you a better idea if you’re deciding what to do. Of course, since everything is measured in probabilities, anything can happen.

(Photo by NCRC)

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