How the probability of the Fed raising/lowering interest rates is calculated
CME's FedWatch tool calculates the market's expected probability of future Fed monetary policy decisions by analyzing the prices in the federal funds rate futures market.
The following is the basic method and formula for the FedWatch tool to calculate the probability of a rate cut (or rate hike):
1. Futures prices and implied interest rates
The price of the federal funds rate futures contract reflects the federal funds rate expected by the market. The formula is as follows:
Implied interest rate = 100−futures price
For example, if the federal funds futures price is 97.50, then the implied federal funds rate is 2.50%.
2. Current federal funds rate range
The Federal Reserve usually sets the federal funds rate in a range, such as 5.25% - 5.50%. The FedWatch tool uses the current target range as a benchmark.
3. Calculating the probability of a rate cut (or rate hike)
The FedWatch tool estimates the probability of a rate cut or rate hike at a future meeting by comparing the implied interest rate in the futures market with the current target rate range. The formula for calculating the probability is as follows:
Probability of rate cut = rate cut points reflected by the futures market / possible rate cut range × 100%
Explanation:
Rate cut points reflected by the futures market: compared with the upper limit of the current target interest rate range based on the futures implied interest rate.
Possible rate cut range: Assuming that the rate cut is 25 basis points (0.25%) each time, the possible rate cut range is generally measured in 25 basis points or its multiples.
4. Weighted average probability
If the market expects that there may be multiple different rates of cuts in the future (such as 25 basis points, 50 basis points, etc.), it is necessary to calculate the weighted average probability.
Weighted average probability = ∑ (probability of different rate cuts × corresponding range)
Example:
Suppose that the futures price reflects the market's expectation that the implied federal funds rate is 5.00%, and the current target range is 5.25% - 5.50%. At this time, the market implies a 25 basis point rate cut, so the FedWatch tool estimates the market's probability of a 25 basis point rate cut in the next meeting.
Through this analysis process, the FedWatch tool provides the market with expectations of the Fed's future policy direction, and these data are of great reference value to investors, financial institutions and economists.
