For example, the Federal Open Market Committee (FOMC) meets in about two weeks, on September 12. What is the probably that the FOMC will cut its target Fed Funds rate from 5.25% to 5% at that meeting? Or maybe even to 4.75%? Using the Federal Funds Futures contracts, the probabilities are 100% of rate cut to 5%, and 73% chance of a rate cut to 4.75%. Here's why:
The October Fed Funds futures contracts settled at a price of 95.1150 on Friday (see chart above). The contracts are priced on the basis of 100 minus the average effective federal funds rate for the delivery month. Therefore, a price of 95.1150 for the October futures contract implies an expected Fed Funds rate of 4.885% for October. This implies that a .25% rate cut in the target Fed Funds rate, from 5.25% to 5% is already fully priced in to the futures contracts, meaning that markets expect at least a .25% rate cut with 100% probability at the September FOMC meeting.
Since the contracts are selling at a price to reflect a Fed Funds rate (4.885%) below 5%, there is also some probability that the Fed will cut rates by .50%. What is that probability?
The implied rate of 4.885% from the futures market is .365% below the current rate of 5.25% (5.25% - 4.885%), suggesting that there is a .365% / .50%, or 73% chance of a 1/2 point rate cut. Further, there is a .365% / .75%, or 46.8% chance of a 3/4 point rate cut in September.
Using the January Fed Funds futures contract, there is a 93% probability that the target Fed Funds rate will be down to 4.5% by early 2008.
I'll revisit this post on September 12 after the FOMC meeting.