Using Federal Funds Futures Rates to Predict Federal Reserve Actions

The Federal Reserve implements monetary policy by making discrete adjustments to its target for the federal funds rate. Such adjustments are believed to have significant implications for other short-term interest rates, so considerable resources are expended on forecasting the timing and magnitude of the Fed’s next move. Many analysts, both inside and outside of the Federal Reserve System, look to the federal funds futures market for an indication of whether the market anticipates a change in Fed policy. Because futures market participants make commitments that are contingent on what they believe the federal funds rate will be, they necessarily look to factors they believe will influence its course. The Fed targets the funds rate, and the overnight federal funds rate stays close, on average, to the Fed’s target. Hence, the federal funds futures rate naturally embodies the market’s expectation of what the Fed will do. Because of how the federal funds futures market is structured, using the federal funds futures rate as a gauge of the market’s expectation for Fed action is trickier than it may at first appear. The purpose of this article is to point out the issues that arise in using the federal funds futures rate to forecast a change in monetary policy. In addition, we present some evidence on the relationships among the federal funds rate, the federal funds futures rate, and the federal funds target rate, and the usefulness of the federal funds futures rate as a predictor of whether the Fed will change its target.