Today I purchased the 30 day federal funds futures contract for February trading on the Chicago Board of Trade for 97.17 meaning that I do not believe that the Federal Reserve will increase the fed funds rate above 2.83% by February. The market has priced in a hike of at least 83 basis points within the next 8 months due to Bernanke’s and other committee members’ recent speeches expressing concern for the weakening dollar and rising inflation. The fear is that the Fed will follow up its hawkish talk with aggressive monetary tightening.

I think the market, which gives the Fed far more credibility than it deserves, has been hoodwinked by Bernanke and co. in the Fed’s attempt to manage inflation expectations. It is actually quite clear that the Fed will not significantly tighten anytime in the near future if we consider two facts.

First, the Fed is a private entity owned by all of the chartered banks of the US. Although congressional oversight and statute can alter the Fed’s responsibilities and control, currrently it does have the authority to act independently without prior approval from the President or Congress. Thus, while the government’s hope is that the Fed will act to promote economic growth, a sound currency, and a stable banking system — its greatest incentive is to act in the interests of its shareholders (i.e. banks).

Second, the balance sheets of banks are rapidly deteriorating as what was once thought to be an exclusively subprime problem, is now beginning to be recognized as a widespread underpricing of risk that has also affected prime real estate mortgages, commercial real estate mortgages, consumer loans, corporate credit, municipal bonds, and derivatives. US banks alone have written off a couple of hundred billions of dollars worth of subprime mortgages and writedowns related to other assets are only beginning. With only $1.2 trillion of capital within the entire US banking system, a huge flood of bank failures is looking increasingly likely.

If these two facts are put together — a Fed that acts primarily in the interest of banks and a continued deterioration in bank balance sheets — then the Fed will continue to promote an easy monetary policy. Indeed, a low Fed funds rate will promote a steep yield curve which should provide some relief to banks who are in the business of borrowing short and lending long.

That said, if oil prices begin to rise parabolically and/or the US dollar depreciates rapidly, it would not surprise me to see the Fed hike by 25 basis points to persuade the markets that it is about to embark on a tightening mission. However, the 83 basis points increase in the Fed funds rate that the futures market is pricing in by February, in my view, has a very small chance of becoming reality.