On the last reading my probability indicator suggested a 45% chance of a US recession (I shall provide an update soon). While below the “trigger” level, such a high reading clearly implies a weak economy, with GDP growing negligibly. The data this week have been consistent with this picture.

Take today’s employment report for December. I think the index of aggregate hours worked in the private sector is a better cyclical indicator than headline non-farm payrolls. As the first chart shows, this measure has shown little growth over the last three months but is not yet contracting – a necessary but not sufficient condition for a recession.

A similar message comes from another sensitive indicator – the new orders index from the ISM manufacturing report. This index plunged to 46 in December but has fallen to 43 or below in recessions historically – see second chart.

If the US economy does fall into recession the culprit will be not the “credit crunch” but soaring energy prices. At the risk of labouring the point, I think premature Fed easing has been a significant contributor to this surge.

My last post suggested the Fed’s “pre-emptive” rate cuts have been counterproductive. Yesterday’s market action illustrates the dilemma the central bank now faces. A shockingly weak ISM manufacturing report caused market players to discount greater future rate cuts, with some even speculating about a move before the next scheduled FOMC meeting on 30th/31st January. These expectations contributed to a sharp drop in the dollar and a surge in commodity prices, with oil and gold hitting new peaks. Yet higher commodity costs will further squeeze consumer budgets and corporate profit margins, offsetting any support to the economy from lower rates.

The way out of this unproductive cycle is for the Fed to make clear that its primary focus is inflation. Further rate cuts should be made conditional on a stabilisation of the dollar and softer commodity prices. Until inflation expectations moderate, policy easing will continue to have little traction on the real economy.

Available evidence suggests the US economy continued to expand in the fourth quarter (e.g. consumer spending rose at a 2.6% annualised rate in October and November). It looks as if the bears who forecast a US recession to start before the end of 2007 will have to roll their predictions into the new year (in some cases for the second year running).

Against this background the 100 bp reduction in the Fed funds rate delivered by the Bernanke Fed since August looks unusually aggressive, contrasting with the central bank's behaviour in prior economic downswings. The Greenspan Fed started to cut rates only two months before the 2001 recession began. In the prior recession in 1990, the first cut coincided with the onset of the contraction.

The speedier response cannot be justified by a more restrictive starting level of rates than in earlier cycles. A reasonable summary measure of policy tightness is the differential between the Fed funds rate and annual growth in nominal GDP. This gap exceeded two percentage points at the time of the first rate cuts in 1990 and 2001 but was close to zero when the Fed eased in August.

Has the Fed’s action supported the economy? The principal effect has been to weaken the dollar and put renewed upward pressure on commodity prices, particularly oil. Reflecting surging food and energy costs, consumer prices rose at a 5.6% annualised rate in the three months to November, squeezing real incomes and depressing consumer confidence. So the Fed has contributed to a likely set-back for consumer spending in December.

Has the Fed taken a risk with inflation? The annual CPI increase hit 4.3% in November and even the ex. food and energy measure has firmed to 2.3% from a recent low of 2.1%. Medium-term consumer inflation expectations in the Michigan survey have returned to their 2007 high of 3.1%. The weaker dollar has contributed to a pick-up in manufactured import price inflation, to an annual 4.6% in November. Even imports from China are now rising in price (up 2.3% on the year).

I think the Fed should have waited for commodity prices and inflation expectations to soften before cutting rates significantly. Premature action has served to boost price risks with little or no benefit to economic activity. The Fed may now find itself constrained from easing further at a time when the economy is looking more vulnerable.