All the debate about the upcoming Fed meeting centers around whether Chair Jay Powell will cut the funds rate by 25 or 50 basis points. However, most economic models indicate that he should be choosing the level of the Fed Funds rate that best fits economic conditions and not its rate of decline from very restrictive levels. Powell choosing between 25 and 50 basis points can be likened to a driver descending a winding mountain road going 60 mph when the speed limit says 25. Common sense says he should slow down immediately, not slowly decelerate to 55 as the road gets bumpier.
In setting the funds rate, the Fed is guided by its dual mandate of fighting unemployment and inflation. The labor market, by the Fed’s own admission, is now in balance, with unemployment at its long-run target of 4.2% and other labor market indicators having moved back to normal range. Year-over-year inflation is slightly over the Fed’s target but very near its goal—and 2% inflation will be achieved soon with oil and commodity prices sinking rapidly. On both fronts, we are virtually at the Fed’s targets.
The Fed indicated at its June meeting that when its dual mandate is achieved, the Fed funds rate should be at 2.8%, a level the Fed and economists call the “neutral rate.” Indeed, this rate is subject to much uncertainty: Among the 19 Federal Open Market Committee (FOMC) members, the range of estimate of the neutral funds rate ranges from a low of 2.4% to a high of 3.8%.
I believe that the neutral rate is nearer the highest estimate—but the current rate of 5.3% is still about one and a half percentage points above this high estimate. Virtually all Fed policy rules, including the well-known Taylor Rules developed by Sanford economist and former Treasury Secretary John Taylor, indicate that the current funds rate should be 4% or lower. If the Fed believes the median estimate made by its own economists and FOMC members in June’s Survey of Economic Projections (SEP), the funds rate should already be in the 3% to 4% range.
Furthermore, Chairman Powell has often repeated the well-known fact that monetary policy works with “long and variable lags,” a phrase popularized by the late Nobel Prize-winning monetary economist Milton Friedman. If that is the case, then staying at or near the current funds rate raises the chance of an economic slowdown or recession significantly.
There are those who claim that the Fed should maintain the funds rate at current levels since the economy is humming at a 2% growth rate and there are few signs of recession. Yet the bond market is pricing in deep cuts in the funds rate over the next 12 months—and 10-year treasury bonds are trading at a very large 150 basis point discount to the current funds rate.
If the funds rate follows the gradually declining funds path set by the Fed in the June “Dot Plot,” then bond traders are wrong, and the 10-year treasury rate will rise significantly, greatly weakening stock, bond, and real estate markets and sharply increasing the probability of a recession.
Jay Powell, much like our speeding mountain driver, may indeed reach the end of his trip safely and declare his policy a “success.” But if the curves in the road get much sharper, then he—as well as the U.S. economy—could find himself careening over a cliff.
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