Updated Thursday, June 11, 2009 11:23 am TWN, By Caroline Baum, Bloomberg

Fed chairman Bernanke stares down the interest-rate bears

NEW YORK -- For the past six months, the federal funds futures market has been a haven for widows and orphans, minus the benefit of coupon-clipping. With the Federal Reserve's benchmark overnight rate set at 0 to 0.25 percent since December and the economy still in need of life support, there was little reason, or impetus, to bet on changes in monetary policy. Daily moves of one-half of a basis point — and that was on a big day — in fed funds futures were purely technical in nature, a function of the contract's cash settlement to the average effective funds rate for the delivery month. That changed last Friday with the release of a less-bad employment report for May. The loss of 345,000 jobs last month, following six months in which the declines averaged 643,000, and a half-point jump in the unemployment rate to 9.4 percent was enough evidence, as far as interest-rate futures traders were concerned, to anticipate the beginning of the end.

So excited were traders to think Fed policy might once again have an implication for interest rates (a price) instead of being a reflection of the size of the Fed's balance sheet (a quantity), they trashed the June 2010 contract to the tune of 58 basis points. The price of the September 2009 contract suggested a possibility of a rate increase in three months while November's gave a tightening move a high probability.

Rear-View Forecasts

The yield on the two-year Treasury note rose 34 basis points, a one-day increase topped only four other times since 1982, according to Jim Bianco, president of Bianco Research in Chicago. Its most recent drubbing, for 44 basis points, took place on Sept. 19, 2008, the day the Treasury's Troubled Asset Relief Program was announced.

A year is a long way off, to be sure. If this crisis has taught us anything, it's that so many economic forecasts improve with the benefit of hindsight. The best and the brightest assured us that housing wasn't a bubble, that the subprime crisis was “contained,” and that the banking system was sound. None of these assertions turned out to be true.

Human nature being what it is, Fed policy makers will probably want to see flowering crocuses, not just their green shoots, before starting to wean the economy from an IV-drip.

History Repeats Itself

The last thing Fed Chairman and Great Depression scholar Ben Bernanke wants to do is “abort the recovery by premature tightening,” which is what his predecessors did in 1936 and 1937, says Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. “At what other time has a 345,000 job loss been a reason to celebrate?”

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