Terminal Funds Rate Down Increasing Odds Of Recession

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By Edward Lambert

I see that Ben Bernanke talks about how the Fed's views of the economy are changing, in particular that the Fed funds rate at the Natural level of production (Terminal as Bernanke puts it) is being revised downward in the past year.

This agrees with my research into effective demand. I see that the Natural real rate has been slipping for a year. This would bring down the Terminal funds rate.

nat real rate

The important thing to realize about this follows from what Bernanke said…

"As mentioned, a lower value of r* (Terminal Fed funds rate) implies that current policy is not as expansionary as thought."

I take that a bit further. A drop in the terminal funds rate brings down the estimation of the Fed funds rate from my effective demand research. In effect, monetary policy is tightening toward a point that would trigger an economic contraction.

est fed rate

(Note: Orange line of effective demand quarterly estimation is smoothed with a light lambda of 10 using HP filter.)

Economic contractions coincide when the Fed rate (blue line) goes over the effective demand estimate (orange line). At this point in time, the orange line is dropping as it did before the two previous recessions. The current situation looks similar to the late 90s when the Fed rate stayed consistent as the orange line dropped below it. If there are further declines in the estimate and the Fed decides to raise the Fed rate and the orange line drops below the blue line, it would signal that an economic contraction is forming.

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