The Federal Reserve is set to meet in September, and one of the biggest questions on everyone's mind is: Should the Fed Fund rate be lowered? While some argue that the rate should be significantly reduced, others maintain that the current rate of 5.50% is appropriate.
A Macro Indicator for the "Fair" Fed Fund Rate
To shed light on this debate, we can examine a macro indicator that has historically shown a correlation with the Fed Fund rate: Nominal GDP growth. As the chart below illustrates, there is a discernible relationship between these two variables. Essentially what this chart shows is that the Fed Fund rate is correlated with growth and inflation.
By analyzing this relationship, we can estimate what the "fair" Fed Fund rate should be based on the current Nominal GDP growth rate. According to recent data, Nominal GDP is growing at a healthy 5.8%.
A Statistical Estimate
Using the historical relationship between Nominal GDP and the Fed Fund rate, we can statistically estimate that the "fair" Fed Fund rate at the current Nominal GDP growth rate is approximately 4.75%. This suggests that the current rate of 5.5% might be slightly higher than what is justified by economic conditions.
Implications for the Fed's September Meeting
This analysis raises important questions for the Federal Reserve as it prepares for its upcoming meeting. Should the central bank consider lowering the Fed Fund rate to align with the estimated "fair" rate? Or should it maintain the current rate.
Based on the relationship above it seems warranted for the Fed to reduce its rate toward 4.75% (implying 0.75% rate reduction from the current level). Which means the logical step for the Fed is to cut interest rate by 0.50% at its September meeting.
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