The

Federal Reserve

turned more aggressive last week. Tuesday's 50 basis-point hike is a departure from the more gradualist quarter-point moves that have far characterized this tightening cycle. The Fed's warning that inflation risks remain confirms market suspicions that

Greenspan

& Co. are prepared to tighten further. That is reflected in the

fed funds futures market. Let me show you how it works.

Fed funds futures offer the best way to assess the market's collective opinion because they are the closest proxy for what we are most interested in -- the direction of the

fed funds rate, the rate that banks charge each other for overnight loans. The Fed influences this rate through its daily operations, providing or draining liquidity. For any given fed funds target level, the yield on 30-year bonds, two-year notes and even three-month time deposits will move.

The chief drawback of the fed funds futures contracts is that they are only moderately traded. This consideration is partly mitigated by the fact that it is the largest futures contract, representing $5 million value. It is 50 times the size of a bond futures contract and five times larger than a Eurodollar futures contract. In addition, the front-month contracts, which cover the next couple of Fed meetings, are relatively more liquid than the more deferred contracts.

The July fed funds futures contract offers the cleanest read for the June Fed meeting. Seasonal pressures associated with quarter and half year-end may distort the month's average fed funds rate, which is what determines the value of the June contract. In addition, since the meeting is late in the month -- June 28 -- it makes the contract less sensitive to subtle shifts in expectations. The July contract implies an expectation of an average fed funds rate of 6.80%. This is found by subtracting the price (93.20) from 100.

On the surface this may appear to be an odd expectation, but look closely. The market is making two judgments. First, the collective wisdom of the market is that a 25 basis-point hike is coming at the June 28 meeting. That raises the current average of 6.50% to 6.75%. The remaining five basis points represent the market's assessment of the probability that the Fed will raise rates by 50 basis points rather than 25.

The market, in effect, has priced in five of the 25 basis points of a second move. One way of expressing this is that the market is pricing in a 25% chance of a 50 basis-point hike. Another way of expressing this is that a quarter of market participants expect the Fed to lift rates by 50 basis points again, while roughly 75% expect the Fed to return to its gradualism.

The following Fed meeting will be held on Aug. 22. Again, such a late date makes the contract less sensitive to subtle shifts in market expectations, so for analytic purposes I prefer the September contract. Volume and open interest -- the number of contracts that have been opened between buyers and sellers -- are much lighter, which reminds us of the tentative nature of the insight offered. At 93.00 it suggests that the Fed funds target will be 7% at the end of the third quarter. A 7% Fed funds rate would be in line with what the

Organization for Economic Cooperation and Development

recently said might be necessary by the end of the summer.

Activity in the more deferred contracts is much lighter but the prices are consistent with the possibility of another 75 basis-point rise in short-term rates that the Eurodollar futures contracts are implying. That would take the fed funds rate to 7.25% by year-end. It is difficult to envisage the market pricing in a more aggressive Federal Reserve this year, even if the precise timing of the moves shifts a bit.

If there is a significant change in market expectations in the coming months, the risk seems to swing toward less Fed tightening than more. Increased volatility in the capital markets and/or evidence that the economy is cooling are two potential events that could prompt a reconsideration of the trajectory of monetary policy.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

chandler.m@mellon.com.