Prime Rate: Probability of A Rate Cut for The August 7, 2007 FOMC Monetary Policy Meeting Now At 32%

The Dow Jones Industrial Average (DJIA) jumped 87.01 points on Wednesday, January 14, 2007. Why? Because Fed boss Ben Bernanke, in prepared remarks made before the U.S. Senate, made some encouraging statements about current and future expectations for inflation, encouraging because a rosy inflationary outlook means that the Fed is now very unlikely to raise rates in 2007, and the probability that the Fed will cut short-term interest rates later this year is now somewhat more likely.

Here are some clips from Dr. Bernanke's testimony:

"...Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude oil. Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated...

...It is encouraging that inflation expectations appear to have remained contained...

...The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next..."

In New York trading, crude oil for future delivery finished at $59.39 per barrel this week, thanks to a return of normal winter temperatures to the northern reaches of the United States. Crude prices should abate once the warm weather returns, unless, like last year, geopolitical tensions and demand from energy-hungry nations like China cause prices to spike to $70+ per barrel. Inflation in the USA: as usual, is all about the light and sweet stuff.

Other factors contributing to the increased likelihood of a rate cut later this year:

Prime mortgages are doing just fine, but, unfortunately, subprime mortgages aren't faring as well. Foreclosures and delinquencies are putting some downward pressure on the already slumping housing sector. Here's a clip from a press release issued by HSBC on February 7, 2007:

"...The impact of slowing house price growth is being reflected in accelerated delinquency trends across the US sub-prime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options. Slower prepayment speeds are also highlighting the likely impact on delinquency of higher contractual payment obligations as adjustable rate mortgages reset over the next few years from their original lower rates.

We have reviewed critically the impact of these factors in determining the appropriate level of provisioning at 31 December 2006 against the Mortgage Services loan book. We have taken account of the most recent trends in delinquency and loss severity and projected the probable effects of re-setting interest rates on adjustable rate mortgages, in particular in respect of second lien mortgages. It is clear that the level of loan impairment provisions to be accounted for as at the end of 2006 in respect of Mortgage Services operations will be higher than is reflected in current market estimates..."

NB: Check out how home equity rates spiked when HSBC shared the bad news.
Earlier today, the Commerce Department reported that there were 1,408,000 housing starts last month, a 14.3% decline from December, 2006, and a 37.8% decline from a year ago (fewer new homes on the market could actually end up helping the housing sector, as inventories are already quite high.)
The Labor Department today reported that wholesale prices -- a.k.a. the Producer Price Index -- fell by 0.6% last month. On Thursday, the Labor Department reported that import prices fell by 1.2%.
On Thursday, the Federal Reserve reported that U.S. industrial production fell by 0.5% (economists were expecting a drop of about 0.1%.)

The Latest Odds

As of right now, Fed Funds Futures traders have odds at around 32% (according to current pricing on contracts) that the FOMC will vote to lower the benchmark Federal Funds Target Rate by 25 basis points at the August 7^TH, 2007 monetary policy meeting.

Summary of the Latest Prime Rate Forecast:

In all likelihood, the Prime Rate will remain at the current 8.25% after the March 21^ST and May 9^TH FOMC monetary policy meetings.
Current odds that the Prime Rate will be cut to
8.00% on June 28^TH, 2007: 14% (unlikely)
Current odds that the Prime Rate will be cut to
8.00% on August 7^TH, 2007: 32% (somewhat unlikely)
NB: Prime Rate = (The Federal Funds Target Rate + 3)

The odds related to Fed 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. Odds may experience a significant shift on the release of the following economic report: