Is The Fed Risking A Recession By Not Cutting Interest Rates?

An update of TMC Research’s Fed funds model continues to suggest that monetary policy should pull back from the current hawkish bias. The model’s current estimate for the optimal Fed funds rate is roughly 4.75%, which is well below the current 5.25%-to-5.50% target range.

TMC’s model is based on five factors that are crucial inputs for monetary policy: 1) inflation; 2) trend in unemployment; 3) real (inflation-adjusted) 10-year U.S. Treasury yield; 4) year-over-year change in U.S. economic output (real Gross Domestic Product); and 5) 10-year/2-year yield curve. See the related research report here.

The model is designed to estimate the optimal Fed funds rate given the current state of the five factors. On that basis, policy is overly tight, which suggests the central bank is raising the risk of slowing growth, perhaps to the point of tipping the economy into recession.

Disinflation increasingly looks entrenched and the Fed appears to be late once again for easing policy – a delay that could needlessly increase economic headwinds and raise the potential for a premature U.S. contraction.

Fed funds futures are currently pricing in moderate odds that policy will remain unchanged at the July 31 FOMC meeting, followed by a rate cut at the September 18 meeting. Using TMC Research’s Fed model as a guide, the delay looks increasingly ill-advised.