Anyway, there are many who still believe the Fed shouldn't cut on Tuesday. I've seen many solid arguments for this case. Some revolving around inflation, which is an argument I find appealing, but ultimately incorrect. Others are focused on moral hazard, which is a case I understand and am to which I'm sympathetic, but still I find unconvincing.
But the case was strong for a Fed cut before the liquidity problem really got going. But don't listen to me, ask John Taylor, devisor of the well-known Taylor rule. As with many ingenious ideas, the Taylor rule is a very simple model. It postulates that monetary policy is basically a function of two things: GDP growth and inflation. That's not much of a stretch. Then you assume that the proper Fed funds level is a function of the difference between GDP growth and potential GDP as well as the difference between current inflation and target inflation. The classic Taylor rule calculation assigns a coefficient to these two gaps and adds them together. Subsequent economists have concocted any number of alterations. Discussion of a few can be found here. Anyway the classic formula is as follows:
R + B1(y - Y) + B2(p - P)
Where B1 and B2 are constants, y is actual GDP growth, Y is potential GDP, p is actual inflation, P is target inflation and R is the base rate. You might think of R as the intercept.
The Taylor rule has done a pretty good job explaining Fed activity in the past, although its ability to predict Fed activity into the future is mixed. Some use this fact to damn the model's usefulness, but I disagree. The fact is that in order to use the Taylor rule into the future, you have to predict the model's inputs. In other words, to predict what the Fed might do 4 quarters from now, you also need to predict GDP and inflation 4 quarters from now. Not too easy. Frankly the data is too damn variable, even the revisions to CPI and GDP can be quite large. But if you want an idea about how tight/easy monetary policy is right now, the Taylor rule is a great guide. If you have a good idea of how tight policy is now, you can make a reasonable forecast as to where the Fed is most likely headed.
Anyway, let's look at the GDP gap.
Note that the estimation of potential is my own. I think that any estimate of potential GDP would be considerably higher than that 1.9% year-over-year growth the economy turned in last quarter.
For inflation, I use the Cleveland Fed's Median CPI measure. My research shows that this is most accurate for use in the Taylor rule. And I assume the Fed's target is 2%. That's broadly consistent with recent Fedspeek.
Inflation remains above the target, but the trend is obviously lower.
By my estimation, the Fed should cut rates down to the 3.75% area based on current data. Will this happen? Historically, this model is pretty accurate in guessing whether the Fed would hike or cut, but not much accuracy on the degree. Again, I think this has a lot to do with the variability of the data. But it also has to do with how Fed activity today impacts the future. If I think current conditions warrant 3.75%, it may be that the Fed cuts to 4.50% and that alone causes inflation or growth to tick up. So instead of putting a lot of weight in the estimated level, I interpret the 3.75% signal as indicating a strong likely hood of more than one Fed cut.
So you can agree or disagree with my case, but anyone in the "Fed Cut = Sub-Prime Bail Out" camp should realize that there is a very reasonable and classic macro economic argument for several Fed cuts right now. I think the liquidity crunch merely closes the blast doors on a September cut.