Are traders in Fed funds futures driving monetary policy?

The Fed funds futures had a significant change in October from not having a firm view concerning a cut in the Fed funds rates to an expectation that a 25 bps cut is almost a lock. Using the futures contract price, there is only a 6% chance of no change by the Fed. The continued credit crisis and tepid growth drove this change in expectations.

So what does the Fed do with this information? We know that the Fed watches closely the Fed funds futures, so if the market is expecting a 25 bps change the Fed may have to give it to them. It is the unanticipated portion of a change that causes a reaction in the market. The Fed’s desire for transparency and clarity means that it would not like market uncertainty about its actions.

The Fed does not work in a vacuum, so if it sees that the market is pricing in a change it has to consider the implications of not changing the rate. The reaction by the markets will be swift. There should be an immediate equity sell-off as well as rates rising along the yield curve. His type of reaction is not what the Fed wants during a fragile period. So if the market wants a cut the Fed may have to give them a cut regardless whether this is what they think it is what is needed in the long-run.