Jeremy Siegel: The Fed should consider deeper rate cuts or risk a recession

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 admission, is now in balance, with unemployment at the long-term target of 4.2 percent and other labor market indicators returning to the normal range. Year-to-date inflation is slightly above the Fed’s target, but very close to its target – and 2% inflation will be reached soon, with oil and commodity prices falling rapidly. On both fronts, we’re basically at the Fed’s targets.

The Fed indicated at its June meeting that when its dual mandate is met, the fed funds rate should be at 2.8 percent, a level the Fed and economists call the “neutral rate.” Indeed, this rate is subject to a lot of uncertainty: among the 19 members of the Federal Open Market Committee (FOMC), the range of estimates for the neutral funds rate ranges from a low of 2.4% to a high of 3.8% .

I think the neutral rate is closer to the highest estimate, but the current rate of 5.3% is still a percentage point and a half above this high estimate. Virtually all of the Fed’s policy rules, including the well-known Taylor Rules developed by economist Sanford and former Treasury Secretary John Taylor, indicate that the current funds rate should be 4 percent or lower. If the Fed believes the average estimate made by its economists and FOMC members in June’s Survey of Economic Projections (SEP), the funds rate should already be in the 3% to 4% range.

In addition, Chairman Powell often repeated the well-known fact that monetary policy operates with “long and variable lags,” a phrase popularized by the late Nobel Prize-winning monetary economist Milton Friedman. If this is the case, staying at or near the current funds rate significantly increases the chance of an economic slowdown or recession.

There are those who argue that the Fed should keep the funds rate at current levels because the economy is humming along at 2% growth and there are few signs of a recession. However, the bond market is pricing in deep cuts in the funds rate over the next 12 months – and the 10-year Treasury is trading at a whopping 150 basis points discount to the current funds rate.

If the funds rate follows the Fed’s June “Dot Plot” path of gradual decline in funds, then the bond traders are wrong and the 10-year Treasury rate will rise significantly, greatly weakening the stock, bond and housing markets and sharply rising the probability of a recession.

Jay Powell, like our speeding mountain driver, can indeed reach the end of the journey safely and declare his policy a “success”. But if the bends in the road get much sharper, then he — like the U.S. economy — could find himself on a cliff.

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