Did the Fed’s rate cuts go too far, too fast?

Investing.com -- The Federal Reserve’s jumbo rate cut last year was meant to loosen the policy reins, but Deutsche Bank (ETR:DBKGn) research warns the central bank may have eased too far, too fast.

“The bond/equity correlation estimates that r* should now be back to pre-GFC levels in the US, at around 2.5%. So, if correct you could make an argument that the Fed Funds rate should now be nearer 5% given where current inflation expectations are,” Deutsche Bank’s said in recent note, highlighting the risk that policy is looser than it appears.

As the bond/equity correlation has flipped from negative to positive in recent years—reducing the efficacy of bonds as a buffer against equity market risk—Deutsche Bank sees a strong case for a higher real neutral rate, or r*. 

"There has been less flight to quality attraction to bonds since inflation returned around 2022, and ever higher deficits don’t help," they added.

Based on this framework, the team estimates r* should now be back near pre-financial crisis levels, around 2.5%, implying that the current policy rate of 4.25% to 4.5% may be at or even below neutral, not above it—if their assumptions are correct.

"If correct you could make an argument that the Fed Funds rate should now be nearer 5% given where current inflation expectations are," the analysts added.

Fed members continue to debate where the neutral level is, but most still lean toward rates being in the restrictive camp rather than accommodative. Atlanta Fed President Raphael Bostic recently said rates were "mildly restrictive," while Fed Governor Adriana Kugler described them as "somewhat restrictive."

As expectations grow that the current level of rates may be closer to, or even below, the neutral level, the path for the Fed to rescue markets with rate cuts continues to shorten.

"We’ve been used to the Fed riding to the market’s rescue when it needs to. While that still might be the case to some degree, their room for manoeuvre has arguably diminished significantly in recent years and is getting harder as deficits march ever higher,"