In setting the Fed’s policy rate, the Fed is guided by its dual mandate to fight unemployment and inflation. The Fed says the labor market is now in balance, unemployment is at its long-term target of 4.2%, and other labor market indicators have returned to normal. Year-over-year inflation is slightly above the Fed’s target, but very close to it – and the 2% inflation rate will soon be reached as oil and commodity prices fall rapidly. On both fronts, we have effectively met the Fed’s goals.

The Fed indicated at its June meeting that if it fulfilled its dual mandate, the benchmark interest rate should be 2.8%, a level that the Fed and economists call the “neutral rate.” In fact, this rate is subject to great uncertainty: estimates by the 19 members of the Federal Open Market Committee (FOMC) range from 2.4% to 3.8%.

I believe the neutral rate is closer to the highest estimate – but the current rate of 5.3% is still about one and a half percentage points above that high estimate. Almost all Fed guidelines, including the well-known Taylor rules developed by Sanford economist and former Treasury Secretary John Taylor, suggest that the current federal funds rate should be 4% or less. If the Fed believes the median estimate of its own economists and FOMC members in the June Survey of Economic Projections (SEP), the federal funds rate should already be in the 3% to 4% range.

Moreover, President Powell has often reiterated 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 that is the case, then sticking to the current policy rate or near it greatly increases the likelihood of an economic slowdown or recession.

Some argue that the Fed should keep interest rates at current levels because the economy is thriving at 2% growth and there are few signs of a recession. But the bond market is expecting significant rate cuts over the next 12 months – and 10-year Treasuries are trading at a very deep discount of 150 basis points to the current rate.

If the federal funds rate follows the gradual downward trend outlined by the Fed in its June “dot plot,” bond traders will be wrong and the 10-year Treasury yield will rise significantly. This would significantly weaken the stock, bond and housing markets and dramatically increase the likelihood of a recession.

Jay Powell, like our speeding mountain biker, may indeed safely reach the end of his journey and call his policies a “success.” But if the curves in the road get much steeper, he could fall off a cliff, just like the U.S. economy.

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