Futures Lose Clarity, Place Fed in Dark on Reaction

By Scott Lanman
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Oct. 28 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his colleagues usually sit down for their interest- rate meetings with a clear idea of what investors think they'll do. Not this time.

One key indicator, futures contracts, no longer provides an accurate signal of where the Fed will set its benchmark interest- rate target. The problem: Traders look at the rates banks charge each other for overnight loans when figuring out their bets on what the Fed will do, and for the last six weeks the Fed has failed to get those overnight rates to line up with its target.


The disconnect means Fed policy makers will find it harder to gauge whether markets will stabilize after the interest-rate decision they make at a two-day meeting starting today. Futures trading suggests a one-in-three chance that Fed policy makers will cut the target by three-quarters of a percentage point, to 0.75 percent. By contrast, only one of 64 economists in a Bloomberg survey foresees that outcome.

Bernanke and his colleagues are ``going to be less confident about the response to their policy action because they don't know what is already priced into markets, and investors are skittish,'' said Vincent Reinhart, a former Fed monetary-affairs director and now resident scholar at the American Enterprise Institute in Washington. ``It just adds another bit of uncertainty.''

Decision Tomorrow

The Federal Open Market Committee will announce its interest-rate decision tomorrow in Washington at about 2:15 p.m. New York time. Of the 64 economists surveyed by Bloomberg News, 35 forecast a half-point reduction from the current 1.5 percent rate, 17 economists expect a quarter-point cut, and 11 predict no change.

Rates are also on the way down in Europe. Jean-Claude Trichet, president of the European Central Bank, said yesterday he may cut borrowing costs at his next meeting on Nov. 6. The Fed, ECB and other central banks pared rates in a coordinated move on Oct. 8.

The misalignment of signals from the futures market is a casualty of the credit crisis: Fed programs pumping more than $1 trillion into the financial system to revive lending have thrown monetary policy off kilter.

The price of federal funds futures is ``irrelevant at this point'' as a signal for probable central bank rate policy, said Alexander Manzara, a broker in Chicago with TJM Institutional Services who has traded the futures for more than 10 years.

Trading in federal funds futures began 20 years ago on the Chicago Board of Trade, which is now part of CME Group Inc. Bloomberg LP's financial-information service provides data on the probabilities of various FOMC moves based on futures and options.

Extolled Futures

Bernanke, 54, extolled the value of the futures when he was a Fed governor in 2004 in research showing the stock market's reaction to FOMC decisions. The paper cited futures data in measuring how much policy changes between 1989 and 2002 surprised investors.

Federal funds futures are a ``convenient, market-based way to identify unexpected funds rate changes,'' said Bernanke's paper, co-written by former Fed economist Kenneth Kuttner.

``If we wanted to do the same thing today, we would not be able to use it,'' Kuttner, a professor at Williams College in Williamstown, Massachusetts, said in an interview yesterday.

Using futures to predict reaction to moves in the central bank's target rate is ``pretty much out the window at this point,'' he said, leaving only outside Fed watchers, trading on betting sites and a few other possible sources.

Robin Ross, CME's managing director of interest-rate products, said the futures are based on the federal funds market rate, and were never ``meant to be anything else.''

`Effective Tool'

At the same time, ``I still think it's a fairly effective tool'' for predicting FOMC decisions, and the contracts do foretell a half-point cut tomorrow as the most likely outcome, Ross said. ``It's not going to be exact and certainly is going to vary from what the target rate is,'' she said, adding that the futures also allow banks to hedge their cost of funds.

What's throwing the futures markets off now is the expansion of Fed lending, which has flooded markets with excess cash and made it difficult to control the overnight lending rate between banks. The Fed's outstanding cash loans to banks and other financial institutions totaled about $700 billion last week, compared with almost nothing a year ago.

The extra funds have expanded the supply of bank reserves, thwarting efforts by the New York Fed to keep the overnight lending rate from falling below the target rate since Lehman Brothers Holdings Inc. filed for bankruptcy Sept. 15.

Rate Gap

The gap between the Fed's target rate and the effective rate, or average daily market rate, was less than 0.01 percentage point in 2008 through Sept. 12. Since then, the spread has averaged 0.40 percentage point. Yesterday, the effective rate was 0.92 percent.

``They have made so many different facilities available to get funds that it is distorting the actual fed effective rate,'', said Lou Brien, a strategist at Chicago-based DRW Trading Group, who has 25 years of experience in markets.

Even an Oct. 6 decision by the Fed to pay interest on excess cash reserves deposited with it by banks has failed to put a floor under the overnight rate. The Fed increased the rate it pays on reserves by 0.40 percentage point last week to move the benchmark rate more in step with the target rate.

Before gaining the authority to pay interest, the central bank kept the federal funds rate close to the target by buying and selling Treasuries on the open market, adding or withdrawing funds from the banking system.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net