Risk Is Rising For A Fed Policy Error

By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com

Markets in recent weeks have been pricing in high odds that the Federal Reserve will cut interest rates at the upcoming Sep. 18 policy meeting. The uncertainty has been centered on the size of the cut. Markets have given moderately higher odds for a 25-basis-points cut. Today’s update TMC Research’s Fed model, however, suggests that the odds now favor a 50-basis-points cut at the least.

The model’s current estimate for the optimal (neutral) Fed funds rate is roughly 3.8%, which is sharply below the current 5.25%-to-5.50% target range. Our revised 3.8% estimate fell abruptly from 4.8% in our July 9 research note (“Is The Fed Risking A Recession By Not Cutting Interest Rates?”).

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 Treasury yield curve.

The model is designed to estimate the optimal Fed funds rate given the current state of the five factors. To the extent that the actual Fed funds rate deviates from the estimate, the difference provides a guide for measuring policy bias. On that basis, policy has become increasingly tight, which suggests the central bank is raising the risk of slowing growth more than warranted and/or expected. Considering that disinflation persists, the potential risk of a policy mistake related to economic growth and the labor market appears to be on the rise.

For a clearer view of how the Fed funds rate compares with the TMC Fed Model estimate, the second chart shows the historical spread for these data sets. The recent spike in the spread to 1.5 percentage points marks the highest level since 2008. Note, too, that the spread has more than doubled since early July.

The process that the Federal Reserve uses to set interest rates is far more complex than can be captured in a model and so the implied forecast should be viewed cautiously. But as a relative gauge of the degree of policy conditions through time, the model suggests that the case may be strengthening for a larger-than-recently-expected rate cut, namely a 50-basis-points reduction. Even if that the Fed cuts by ½ percentage point, that would still leave the target rate at a 5.0%-to-5.25% range – far above what is arguably a neutral rate of approximately 3.8%, based on our model.