This week, the Federal Reserve is set to cut interest rates for the first time since 2020.

And economic data is giving the central bank the green light to do so.

Congress tasks the Fed with maintaining price stability (i.e., low inflation) along with full employment.

Job growth has been cooling recently. The August payrolls report showed 142,000 jobs created during the month.

That missed expectations. Plus, the three-month payrolls average is the lowest in four years.

And now inflation is finally coming under control.

Consumer price inflation shot up to 9% in 2022. But higher interest rates are helping to bring inflation down.

In the latest report, the Consumer Price Index (CPI) fell to 2.5% compared to last year. That’s the lowest CPI reading since 2021.

Moderating inflation and a cooling labor market are leading to the Fed’s rate cut this week.

That has investors’ hopes up over a coming rate-cutting cycle.

But there are signs that the Fed is already too late…

Policy Error in the Making?

The Fed has a history of making “policy errors.”

Central bank authorities sometimes screw up and push monetary policy too far in one direction.

They deliver too much stimulus to the economy, resulting in too much inflation.

Or they keep interest rates too high for too long, knocking the economy off balance.

The latter is what we may be seeing now…

The problem is that raising interest rates takes six months or more to impact the economy.

By the time the central bank realizes the damage being done, it’s often too late to head off a recession.

For example, the Fed started cutting rates five months before the recession hit during the 2008 financial crisis.

And the Fed could be making another mistake today by being too restrictive.

Just look at the chart below:

The chart shows the Fed funds rate (red line) and the level of CPI inflation (blue line). The Fed funds rate is the highest above inflation since just ahead of 2008.

And one corner of the market is starting to panic.

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What Lies Ahead

Economists do a lot of guesswork to figure out the Fed’s next move and where rates should head.

But they could do better by just tracking U.S. Treasury yields.

More specifically, the 2-year Treasury yield has a reputation for anticipating changes in the Fed funds rate.

The 2-year yield can also hint when there’s a policy error in the making.

Take a look at the chart:

The green line is the 2-year yield, while the blue line is Fed funds.

Just ahead of the last three recessions (shaded areas on the chart), the 2-year yield dives below the Fed funds rate.

That’s the bond market’s way of pricing what lies ahead.

And the 2-year yield is dropping quickly once again.

Now, that doesn’t mean a recession is just around the corner.

But it’s certainly worth following this development closely.

After all, this is often the bond market’s way of saying the Fed is staring down another policy error… and can’t cut rates fast enough to avoid trouble.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict