0.5%, here we come: Jobs data cement view on Fed cut

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With today’s awful October employment report, markets believe with near 100% certainty that the Federal Reserve will cut its benchmark short-term rate in half on or before policymakers’ next meeting Dec. 16.

Trading in futures contracts on the federal funds rate, the Fed’s key rate, now implies a 97% probability that the central bank will slash the rate from the current 1% to 0.5%, according to Bloomberg data.

A week ago the probability of a half-point cut was pegged at 55.3%.

Now, one school of thought is that the Fed’s official rate, at 1%, has become meaningless because the actual market rate for federal funds already is well below 1%.

The federal funds rate is what banks charge one another for overnight loans. The Fed manages that rate by adding money to the banking system or by taking it away.

The Fed, as everyone knows, has pulled out all the stops to flood the financial system with money, trying to break the credit crisis and keep the economy from a catastrophic collapse.

Over the last five days, the federal funds rate has averaged a mere 0.23%, notes Brian Bethune, an economist at Global Insight in Lexington, Mass.

So what would be the point of cutting the official rate from 1% to 0.5%? Because that’s the only way to get banks to reduce their benchmark lending rate, the prime rate, which always moves in tandem with official Fed changes.

The prime now is 4%. If the Fed goes to 0.5% on the federal funds target, the prime should drop to 3.5%. In turn, business and consumer borrowers who have loans pegged to the prime would get a rate cut. That would include many borrowers with home equity credit lines.

Many banks clearly aren’t interested in making new loans in this economy, but every rate cut for existing borrowers means more money left in their pockets. It’s a way to force the banks to pump money back into the economy, whether they want to or not.