Should Interest Rates Go Up?

By Douglas Rice | August 17, 2009 AAA
Should Interest Rates Go Up?

The Federal Reserve (the Fed) recently announced that the economy is leveling out and that the Fed is moving toward phasing out the emergency measures it took over the past year. The Fed also left interest rates unchanged at near zero, and said that they are likely to remain there for an extended period to guide the way to recovery. (For background reading, check out our tutorial section What Is The Fed?)
Not Cutting It
But for job seekers and investors, leveling out isn't going to cut it. What they are looking for is a growing economy that will increase job prospects and asset prices. When the Fed says it is leaving interest rates alone for an extended period of time, it is also saying that it does't fear inflation, a sign of a growing economy, for that same extended period of time. As the main tool to fight inflation is interest rates, rising interest rates will be a strong signal that the economy is really starting to grow. If the Fed isn't going to raise interest rates anytime soon, then growth prospects seem distant. (Learn more in Translating "Fed Speak" Into Plain English.)

Monetary Policy
The Federal Reserve's Federal Open Market Committee (FOMC) sets the key federal funds interest rate. The federal funds rate is the interest rate at which banks lend money to each other and what the media is referring to when they say the Fed has changed interest rates. This is key as borrowing money from other banks is a quick way for banks to raise capital. So if a bank wants to lend out more money than it has, instead of waiting for more deposits from customers, it can borrow from other banks. The lower the rate, the more they tend to borrow and lend, so economic activity increases. When the rates move higher, banks borrow less, lend less, and the economy slows. This is the key tool of monetary policy so it's worth watching. (Learn more in Formulating Monetary Policy.)

At every meeting of the FOMC, its members review economic conditions and decide if they should change the Federal funds rate. The next meeting is September 22-23, then November 3-4, and December 15 – 16. In 2010, the calendar starts with meetings in January, March, April and June. The media covers this as a breaking story and the instant the decision is released markets can move on the news.

Recent Indicators
Looking at recent history of the federal funds rate shows the historic low of 0.0% to 0.25% (25bps) was set in December of 2008 and has stayed there. As it's basically impossible to set a negative interest rate, it can't lower the rate any more. So the only direction to go is up. But it's impossible to accurately predict when the Fed will raise interest rates. At this point, it's likely that it doesn't know yet either. But looking at the information that exists today may provide some insight into what may happen and one of the main indicators of potential change in the federal funds rates comes from the options on federal funds futures traded on the Chicago Board of Trade options market.

federal funds Futures
An option on federal funds futures is basically a bet on the future federal funds rates. While betting on this is best left to professionals, the prices of option contracts on federal funds futures can be used to infer the market's expectations of future Fed moves in the form of implied probabilities. The implied probabilities show how the traders feel about what will happen in the future. While this is not a perfect indicator, it does show how people feel that are betting with real money. They could be wrong, but no one is bluffing or trying to mislead anyone.

The implied probabilities can be found at the website of the Cleveland Federal Reserve Bank. This will change daily as the market moves. After the August FOMC meeting statement said that the Fed would leave interest rates alone for "an extended period," the Cleveland Federal Reserve Bank showed the probability that the federal funds rate will rise in September at 0.0%-0.25% is almost 0% and the probability in November is a only a 10%. This was very close to existing expectations. The probability of a rate increase in January fell from 54% to 36% as traders expected that the Fed would likely move rates up, but now they aren't so sure.

When Will They Raise Interest Rates?
While the federal funds futures is far from a crystal ball, it can shed some light on when we may see real growth. Right now it's showing that we are still quite a few months away from any movement from the Fed on interest rates. As for when the Fed will raise interest rates, keep watching the federal funds futures for clues. Their predictions are as good as any.

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