Predicting the Probability of FOMC Rate Decision: An Ordered Probit Approach

What will be the FOMC rate decision? Every six weeks the financial markets consider this critical question. The FOMC sets the stance of the U.S. monetary policy and provides a target for the federal funds rate (fed funds rate). This paper presents an ordered probit approach that estimates the six-months ahead probability of three distinct scenarios of the FOMC decision: raise the fed funds target rate, reduce the rate or keep the rate unchanged. The traditional way of forecasting the interest rate is to predict a single level of the fed funds rate; however, this approach suffers two problems. First, it is not useful for the option/risk facing decision-makers. Second, point estimates of interest rate convey a sense of overconfidence. Our method is different and more practical for those who must hedge their portfolios, but it is also useful for policymakers, investors and consumers who can attach a probability with each more-likely scenario of future fed funds target rate trend.

One key suggestion of our ordered probit model, which may be crucial, is that since April 2013, the probability of a rate reduction has trended downward. Currently, based on the July 2014 data, the probability is 18 percent, which is the lowest since December 2007. At the same time, the model has predicted an increasing probability of a rate hike since April 2013 and, at present, the probability of a rate hike is 24 percent. This pattern implies that there is a significant chance of a change in the stance of the monetary policy in the near future and that this chance should be priced into financial assets. In addition, a persistently higher probability for a particular FOMC rate decision scenario is consistent with the episodes in the 1990s and 2000s when the model predicted a relatively higher probability for an extended period of time for a particular stance of monetary policy and that prediction was matched with the subsequent FOMC rate decisions.

Key Words: Ordered Probit; FOMC; Probability.

JEL Classification: E5; E52; C3; C35.