The chart below shows the real level of the US Fed funds rate, defined with respect to the annual change in the consumption price index excluding food and energy – the Fed’s favoured inflation measure. After yesterday’s cut the real Fed funds rate stands at just 0.8%.

Real Fed funds peaked at a lower level in the current cycle than before the last six recessions. This has been one factor preventing my recession probability indicator from breaching the 50% “trigger” level.

As the chart shows, a real Fed funds rate of 0.8% was reached only near or even after the end of prior recessions. (In one case – the 1981-82 recession – it bottomed well above this level.) The shortest interval between the onset of a recession and real Fed funds reaching 0.8% was five months (in 1980). 

Pessimists argue that the economy entered a recession in November or December. Employment trends will be a key influence on the determination of the official arbiter, the National Bureau of Economic Research. Tomorrow's offical numbers will provide more information but the solid ADP payrolls report for January suggests employment has yet to turn down, implying the pessimists’ case is weak.

The Fed has embarked on an extraordinary monetary policy experiment, cutting official rates to post-recessionary levels when there is still little compelling evidence that a contraction has actually started.

One risk with this strategy is that the Fed is squandering ammunition that would be better reserved until significant economic weakness is confirmed. Premature easing may have boosted inflationary pressures with little positive impact on the real economy – see here.

The alternative risk is that the Fed is too pessimistic about economic prospects and combined monetary and fiscal stimulus will produce a strong rebound later in 2008, pushing inflation further above target. Anyone under any illusions about the Fed’s superior forecasting ability should read Chairman Bernanke’s monetary policy testimony to Congress in February 2006, containing the memorable phrase “a modest softening of housing activity seems more likely than a sharp contraction”.

Political and Wall Street pressure on the Fed is enormous but I think these risks warranted more measured cuts.