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November 29, 2007
Market expectations for a rate cut become solidified
It's been a while since we have looked at the fed binary options from the Chicago Board of Trade. And there was some significant movement today too.
Implied probability of at least a 25 bp cut is now at around 87% (call option with 95500 strike price closed at 87, up 9 from yesterday's close).
Implied probability of at least a 50 bp cut is now at around 30% (call option with 95750 strike price closed at 30, up 10 from yesterday's close).
Payoffs are based on the target fed funds rate at the end of December. Hence these take into account the possibility of an intermeeting cut.
It's impossible to point to one factor as being the prime mover here. There's Donald Kohn's speech where he says,
Another consequence of operating under a high degree of uncertainty is that, more than usually, the potential actions the Federal Reserve discusses have the character of "buying insurance" or managing risk--that is, weighing the possibility of especially adverse outcomes. The nature of financial market upsets is that they substantially increase the risk of such especially adverse outcomes while possibly having limited effects on the most likely path for the economy.
See also, Frederic Mishkin from earlier this month.
We also have the steady drum beat of negative housing news along with a jump in jobless claims. Not even a GDP revision can overcome that. (Of course, the GDP revision is not fooling anyone into revising their forward looking forecast. Barry Ritholtz calls the revision "fanciful".)
But two Fed officials have expressed a clear preference to hold rates where they are. One votes at the next meeting. The other will be a voting member next year. (Reuters)
CHICAGO (Reuters) - Two Federal Reserve Bank officials hinted strongly on Tuesday that they would not support an interest rate cut in December, contending that the Fed has provided enough insurance against financial turmoil and would risk opening the door to higher inflation.
The comments from Chicago Fed President Charles Evans and Philadelphia Fed President Charles Plosser put the central bank at odds with financial markets that are anticipating a series of rate cuts over the next few months.
...
But Evans and Plosser, while acknowledging risks to the economy, suggested that further cuts to the federal funds rate, the bank's most powerful policy tool, might not be the right solution to the credit market's problems.
...
"In some circumstances, lowering interest rates may prolong the painful process of price discovery," he said in a speech to the Rochester University Simon Graduate School of Business.
I think I may use that quote in my classes next week.
The beat goes on.
Posted by William Polley at November 29, 2007 12:06 PM
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