Around 2:15 PM EST today, we will know the FOMC’s decision on interest rates.  While we expect no formal change to the effective 0.00% to 0.25% effective Fed Funds rate, we expect traders to pay closer and closer attention to what Ben Bernanke and friends say regarding when the ultimate exit strategy will come on the free money and what to expect as far as ongoing securities purchases and other liquidity programs. More importantly, we will be paying close attention to just exactly when the markets start determining the forward date for when rates will rise by looking at Fed Fund Futures over the next day or two.

As we noted over the weekend, this might not be the last FOMC statement without a formal exit from the Federal Reserve from its free money policy.  But there is also the notion that rates could get higher and faster than what the Fed Funds Futures are predicting.  We are already hearing media reports over reverse repos being used to take cash out of the economy, but to what extent is not yet known.

The FOMC, Treasury, Fed governors, and other officials have just about all been less and less doom and gloom of late.  Ben Bernanke went as far as to say that the recession is technically over.  Tim Geithner said he is eager, “no one is more eager than me…”, to get off the free money and bailout climate we have been on.  And Fed presidents and governors are talking about the return of growth in presentations, despite how ‘fragile’ and ‘not out of the woods yet’ implications they make.  And the Fed and Treasury have slowed on the endless asset and securities purchases.  By our take, the single trifecta as a driving force that is keeping the rate artificially at zero here is the army of unemployed, another army of underemployed, and a rise in poverty levels.  The Fed has a dual mandate, one of protecting the environment from inflation via rates and other policy tools, and one of keeping employment strong.

The army of unemployed is still more than 6 million via continuing jobless claims.  The weekly jobless claims have yet to break under the 500,000 level, and that figure has to realistically get closer to around 400,000 before there will be any real pass-through of employment.  The official unemployment rate was 9.7% and we are not expected to see a drop yet as many are still calling for unemployment to hit 10%.  And the unofficial unemployment of those forced to work only part-time, on small contract, and those working in jobs far under their qualifications is over 16% by some counts.  While unemployment is considering a lagging indicator that is one of the last to see an improvement during the start of economic recovery, it seems that the bet is that Ben Bernanke and friends are not going to tell about 10 of every 100 workers that they now have to cope with a tightening bias on rates on top of their misery.  But there is also the notion to add in that employers can milk more from their current workers rather than bring back more laid off workers.

After running some calculations, there is just no change expected today in Fed Funds today.  In fact, according to Fed Fund futures, there is only a small chance that the zero rate target will even get to 0.25% in November or December.  At the start of this week the January 2010 was effectively close to a 90% chance of a 0.25% rate, but that is now closer to 85% and it is still not until February 2010 that the 0.25% Fed Fund threshold is formally expected.  Maybe the bets are that the unemployment will cap out at 10% and not stay there for very long, but the opinion of the day is that we still face a jobless recovery with those experiencing the growth again still being very frugal and very cautious and informed when they make purchases.

As this is the FOMC day, we’ll hold off on looking too far out because traders are making changes on the front end and farther out now.  There is still a chance that in April 2010 we have a 0.50% Fed Funds rate  and effectively an implied 100% chance of 0.50% Fed Funds rate by May 2010.  The farther out you go, the less liquid and less accurate these are, but last week there was effectively a 1.00% Fed Funds rate expected by September-2010, although that now looks closer to a 95% pricing-in event.    The pricing matrix for Fed Fund Futures is here.  Again, this is only one tool.

The continued promise from Uncle Ben has been for very low rates for ‘quite some time’ and it is probably fair to assume that that is the FOMC’s intent.  We also think that the Fed would rather see 1% higher inflation than another 1% in unemployment.  But the pressure is almost there in the economy and in the weak  US-Dollar that could mean the near-0% policy has to come off at some point relatively soon.  We’d also not that there is almost never a “one and done” on the rate hikes. There is also a possibility that the FOMC will have to defend the US dollar to keep it from becoming the Gringo Peso. Much depends on how commodities trend and if this 50%+ recovery in stocks can keep its gains and keep running.  We’d also note that the US population saw a gain in its wealth in the second quarter for the first time in two years.

A fair guess is that if there are no blow-ups in major corporations from this October’s earnings season and no major reversal events of the unexpected nature come in, then we’ll have an official interest rate figure again on Fed Funds by the end of 2009 and be back up at 0.50% later in the first quarter of 2009.  That is not unanimously shared, but ultimately Bernanke may have to pull the trigger even if he would rather hold off. If a sooner than expected return to higher rates comes, then our second estimate is that Fed Funds will be at 1.00% going into next summer rather than at the end of it.

Even if the official policy remains to keep rates low for some time into the future, the unofficial policy and liquidity tools that have been used are likely to see a contraction.  By some measures, they already have.

JON C. OGG
September 23, 2009

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