Monday, December 31, 2007

Fed Funds Rate Predicting

A discussion about Ben Bernanke and the Fed would not be complete without a discussion of where the Fed Funds Rate is going? The current rate is a 4.25%. How can you predict this ahead of time, and perhaps ahead of the markets? Can managers prepare for these changes? Predicting what decision the Fed is likely to make can be a valuable tool for financial analysts, managers, and investors. An article by Michael Hunstad in the November "AFP Exchange" journal describes 5 predictive indicators that can be observed prior to a fed decision.

Sudden CPI Shock: A slow growth or decline in the CPI is less likely to prompt Fed Rate action than that of a rapid, sudden jump. Should there be a spike in the CPI, inflation may be perceived as quickly rising and the Fed will be more likely to raise rates to curb spending.

Long Leading Indicator: Put out by The Conference Board, this is an indicator relating to economic growth. When there is stronger growth, the Fed may be more likely to raise rates to keep the economy from overheating. The Fed may also be more likely to lower rates if economy appears to be contracting.

Corporate Credit to 10-Year Treasury Spreads: The difference in yield between a "Baa" rated corporate bond and a 10-year U.S. Treasury Bond can be important. The greater the spread, the greater the perception of risk of companies with low credit ratings. As these companies are often the ones most affected by a recession, a greater spread can be a leading indicator of a coming downturn in the economy. The Fed in observing this my lower rates to reduce the severity and duration of the recession.

Spread between 6-mo T-Bill and Fed Funds Rate: When these bonds approximately equal the Fed Funds Rate, the economy is in near equilibrium. However, a deviation in which the 6-mo T-Bill rate is lower than the Fed Funds Rate represents investor confidence in anticipating a rate cut. As Mr. Hunstad states in his article "This results as T-Bill investors are willing to take a lower yield today because they expect future interest rates to be lower". The Fed may be likely to move in that anticipated direction.

Previous Fed Action: This is the easy one. A Fed Funds Rate in motion is likely to remain in motion, a Rate at rest is likely to remain at rest.

Overall, observing these 5 indicators can help you make more educated predictions about where the Fed Funds rate may be headed. For more detailed information, I suggest you read the entire article in the November "AFP Exchange" magazine.

Thanks for visiting. I would love to hear from some analysts, managers, and other professionals. Please drop me a comment below and discuss your own insights into predicting the Fed Funds Rate.
--------Sincerely, Trevor Stasik.
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