Wednesday, January 23, 2008
Interest Rates
Here is the front page article on CNBC about what happened in the markets today. In addition to the 75bps cut today they are expecting 50bps more next week at the regular scheduled FOMC meeting. Today in Econ 435 (I strongly recommend taking this class) we talked about interest rates are essentially prices determined by consumption. In this manner any sort of prediction model will not be accurate at all because the supply or demand could change at any time. You don't predict prices, the market makes them and same goes for interest rates.
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Well, actually you the market doesn't freely set the Fed Funds rate (which drives short-term lending rates) because the Fed essentially has monopoly pricing power in the market for non-borrowed reserves (Federal Funds). So they can effectively set the rate with intervention. The market is pricing in another 50bps cut based on futures contracts selling on the CBOT. Here is a link to the contract which will give you 10-minute delayed price information- http://www.cbot.com/cbot/pub/page/0,3181,1563,00.html.
Each futures contract represents the implied average Fed Funds rate during the month of the contract. For example, the Feb08 contract is trading at 97.08 right now. To infer what the market thinks interest rates will be one has to understand that the contract costs 97.08 and will pay out 1.00 upon expiration. No-arbitrage means that the expected interest rate must be (roughly) 1-97.08 or ~3%. That is 50bps lower than the current Fed Funds rate, so the total activity of traders in Fed Funds Futures predict a 50bps cut at the next meeting. (This is sort of how it works... I think I might make a more formal, full explanation a topic for a post soon)
Interest rates will saty low.
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