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Prime Rate

also known as the Fed, National, U.S. and WSJ Prime Rate

Friday, September 07, 2007

Decline In Non-Farm Payrolls Virtually Guarantees A Rate Cut for September 18

Investors on Wall Street expect the Fed to lower short-term interest rates on September 18. But the Fed isn't going to lower rates just because Wall Street wants it to.

The Fed is not going to lower short-term rates in response to the current credit crunch happening in the financial markets. Furthermore, the Fed is not going to lower rates in order to help the struggling housing sector.

The Fed, however, will lower rates if one or more of the major macroeconomic numbers, like employment or GDP, warrant a rate cut. Earlier this morning, the Labor Department delivered those numbers.

According to the Department of Labor, the American workforce lost 4,000 jobs last month, the first month-to-month decline in non-farm payrolls since the summer of 2003. The numbers in the August jobs report are very significant for the Fed, because the group can now lower short-term interest rates (rationale: a preemptive strike against recession) without having to worry about being accused of caving in to what Wall Street wants.

Right now, the fed funds futures market is 76% certain that the Fed will cut the benchmark Fed Funds Target Rate by 50 basis points on September 18, with 24% betting that the Fed will opt for a 25 basis point cut. In other words, the market is 100% sure that the U.S. Prime Rate will be cut by at least 0.25 percentage point on September 18 (the current U.S. Prime Rate is 8.25%.)

I'm thinking that the Fed will lower rates by 25 basis points on September 18, then possibly lower rates by another 25 basis points on October 31. I don't think the Fed is going to cut rates aggressively, i.e. by 50 basis points in one shot, while the broader economy is still quite strong, and risk stoking the flames of inflation. Yes, the news that non-farm payrolls declined last month wasn't positive, but the unemployment rate held steady at a reasonably healthy 4.6%. And remember, the cost of crude oil can have a significant impact on inflation, and crude for future delivery finished the week at $76.70 per barrel (crude was at $66.25 at this time last year.)

The Latest Odds

As of right now, the investors who trade in fed funds futures have odds at 100% (according to current pricing on contracts) that the Federal Open Market Committee (FOMC) of the Federal Reserve will elect to lower the benchmark Federal Funds Target Rate by at least 25 basis points at the September 18TH, 2007 monetary policy meeting.

Summary of the Latest Prime Rate Forecast:

  • Current odds that the Prime Rate will be cut by at least 0.25 percentage point after the September 18TH, 2007 FOMC monetary policy meeting: 100% (certain)

  • NB: U.S. Prime Rate = (The Federal Funds Target Rate + 3)

The odds related to federal-funds futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are continually changing, so stay tuned for the latest odds.

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