When I am on the road talking to clients about the economy and the path of Federal Reserve policy, the most frequent question I get is: If the economy is growing how can policy be restrictive?
The answer lies not so much in the current economy as it does in what awaits if the Fed continues along its current restrictive path.
With underlying inflation having fallen to between 2% and 2.5%, and the federal funds rate standing at 5.5%, capital investment has become prohibitively expensive for many businesses.
Keeping rates at such a high level risks pushing the economy into an unnecessary recession.
It’s why Fed policymakers have signaled that they will reduce their policy rate at their meeting this week. We feel the Fed will cut its policy rate by 25 basis points; the market is pricing in a 62% probability of a 50 basis-point cut.
But along with a cut, the Fed will need to map out the timing and depth of its new regime of lower interest rates. The Fed, after all, has a dual mandate of price stability and maximum sustainable employment. Its coming pivot on rates is a sign of its new focus on the employment half of its mandate.
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From my point of view, both the journey and the destination of policy are far more important than whether the Fed starts out with a 25 basis-point cut or a 50 basis-point cut.
Moreover, if one looks at the real federal funds rate, presented here (for simplification purposes) as the federal funds rate less the top-line consumer price index, that rate stands at 3%.
That level is well above our preferred estimate of the neutral rate, or the Holston-Laubach-Williams estimate of the natural interest rate, which stands at 0.75%.
Over the medium term, we expect an inflation rate of around 2.5%, which implies a terminal policy rate of roughly 3.25%.
Given that the midpoint of the Fed’s current nominal policy rate sits between 5.25% and 5.5%, this implies that the central bank will need to reduce the federal funds rate by 225 basis points to get policy to neutral in order to make policy less restrictive.
Not surprisingly, current market pricing implies that the policy rate will fall to a range approximating neutral by the middle of next year.
There are a lot of heroic assumptions that underscore such market pricing that may not materialize. But it’s clear that the current policy rate is restrictive and poses a risk to the economy, as the financial channel is showing.
