More Fed Cuts Needed | Nasdaq

After 25bp cut, Fed Funds is now 4.75%

On November 7, the Fed cut rates for the second time in this rate cut cycle, lowering the Fed Funds rate 25bp to 4.75% (chart below, darker red line).

Fed Funds rate is well above “neutral”

Chair Powell also signaled that the Fed’s plan remains to carefully lower the Fed Funds rate closer to its “neutral rate” – the rate which neither boosts nor slows the economy.

The challenge for the Fed is that the precise neutral rate is unknowable in real time – it changes, depending on the trend rate of GDP growth and inflation. Given this, economists try to model it, and markets try to estimate it.

At the last Fed meeting in mid-September, markets and the Fed saw rates settling around 3% in the next couple years – their estimates of the neutral rate.

Now, however, with the economy looking stronger and markets expecting supportive fiscal policy, markets see rates settling around 3.85% late next year (lighter red line).

No matter which neutral rate estimate you use, the current Fed Funds rate is well above it, meaning monetary policy is still quite restrictive.

Fed has history of overshooting neutral and causing recession

Historically, this has been a recipe for recession. That’s because restrictive rates slow the economy, and if rates are too restrictive for too long, we get a recession.

This is what we saw ahead of the 1990-91, 2001, and 2007-09 recessions (chart below, red circles). The Fed raised the Fed Funds rate (red line) above the neutral rate (brown line), slowing the economy so much that it fell into recession (grey-shaded areas).

Then, in response, the Fed cut rates sharply, bringing them well below the neutral rate to support the economy’s recovery. At last, once the economy recovered, the Fed raised rates, repeating the process all over again.

Right now, the Fed Funds rate is still 125bp above the New York Fed’s neutral rate estimate. That’s the biggest this gap has been since the mid-90s. On the plus side, that’s also the last time the Fed managed a soft landing (green circle).

So, with the Fed Funds rate well above the neutral rate, rates should (and could) come down a lot over the next year. Otherwise the Fed risks repeating history and causing a recession.

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