Fed Funds Probability
Encyclopedia
Federal funds probability is the probability
of actions taken by the Federal Reserve System
of the United States
at upcoming Federal Open Market Committee
(FOMC) meetings. At every meeting of the FOMC, its members decide whether to increase, decrease, or leave the Federal funds rate
unchanged after reviewing the nation's economic conditions. Financial markets constantly predict the Federal Reserve Systems' moves by trading Federal Reserve funds (Fed funds) futures contract
s on the Chicago Board of Trade
(CBOT).
As such, the prices of the CBOT Fed funds contract reflect expectations of Federal Reserve (Fed) actions and can be used to calculate the implied probability of action at each FOMC meeting. This phenomenon was perceived by Gerald Lucas and Timothy Quek, fixed-income strategists at Merrill Lynch
who published the article "Front-End Pricing Report Guide" in the Merrill Lynch Global Fixed Income Research report of Nov. 10, 1995. They created a financial model to calculate the probabilities at FOMC meetings and published their Fed funds probability reports for their clients. Ever since, the financial markets have tracked this probability, which is frequently reported by financial media such as CNBC
and MarketWatch
.
The Fed funds probability report has a significant role in financial markets. Market maker
s and traders
use this information to trade financial assets. Federal Reserve decision-makers use the information to assess market expectations. By using the report, and other indexes, markets can constantly adjust to changes in the economic outlook, reducing the chances of a shock to the financial system.
Probability
Probability is ordinarily used to describe an attitude of mind towards some proposition of whose truth we arenot certain. The proposition of interest is usually of the form "Will a specific event occur?" The attitude of mind is of the form "How certain are we that the event will occur?" The...
of actions taken by the Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
of the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
at upcoming Federal Open Market Committee
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...
(FOMC) meetings. At every meeting of the FOMC, its members decide whether to increase, decrease, or leave the Federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
unchanged after reviewing the nation's economic conditions. Financial markets constantly predict the Federal Reserve Systems' moves by trading Federal Reserve funds (Fed funds) futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s on the Chicago Board of Trade
Chicago Board of Trade
The Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million...
(CBOT).
As such, the prices of the CBOT Fed funds contract reflect expectations of Federal Reserve (Fed) actions and can be used to calculate the implied probability of action at each FOMC meeting. This phenomenon was perceived by Gerald Lucas and Timothy Quek, fixed-income strategists at Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
who published the article "Front-End Pricing Report Guide" in the Merrill Lynch Global Fixed Income Research report of Nov. 10, 1995. They created a financial model to calculate the probabilities at FOMC meetings and published their Fed funds probability reports for their clients. Ever since, the financial markets have tracked this probability, which is frequently reported by financial media such as CNBC
CNBC
CNBC is a satellite and cable television business news channel in the U.S., owned and operated by NBCUniversal. The network and its international spinoffs cover business headlines and provide live coverage of financial markets. The combined reach of CNBC and its siblings is 390 million viewers...
and MarketWatch
MarketWatch
MarketWatch operates a financial information website that provides business news, analysis and stock market data to some 6 million people. MarketWatch offers personal finance news and advice, tools for investors and access to industry research. Along with its flagship website, the company operates...
.
The Fed funds probability report has a significant role in financial markets. Market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
s and traders
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
use this information to trade financial assets. Federal Reserve decision-makers use the information to assess market expectations. By using the report, and other indexes, markets can constantly adjust to changes in the economic outlook, reducing the chances of a shock to the financial system.