$140 oil threatens to abort the expected second-half recovery in US growth. The perennial recession forecasters have another chance of glory – though not for the reasons they suggested.

Markets have responded to mounting gloom by lowering expectations for official interest rates later in 2008 – some economists are even talking again of cuts. Yet excessive Fed easing is the prime cause of the problems the economy now faces.

As the chart shows, the Goldman Sachs commodity price index stabilised from mid 2006 as the Fed moved its target Fed funds rate above 5%. The explosion upwards started only when the Fed went into reverse and cut rates aggressively from last autumn. Prices have risen by over 60% in less than nine months – equivalent to the gain over the prior three years. Posts here in late 2007 and early 2008 argued that the Fed’s policy was misguided and would fuel inflation rather than stimulate the economy.

Commodity prices – particularly energy – may now be above the level needed to equate demand and supply over the medium term. Markets that overshoot fundamentals sometimes fall back to earth just under the weight of their overvaluation. More usually, a tightening of monetary conditions is necessary to trigger the adjustment. For example, the TMT bubble of the late 1990s burst only after the Fed raised official rates from 4.75% to 6.5%.

The Fed has damaged the economy by buckling to the demands of Wall Street interest rate doves. A commitment to a stable dollar, backed up if necessary by policy tightening, would be the best route to a recovery. More of the same is a recipe for continuing woes.

I am on annual leave for the next two weeks so MoneyMovesMarkets will be taking a break. Please check back in late July.

Two weeks ago my MPC-ometer had a slightly hawkish tilt, suggesting an 8-1 vote for unchanged rates at this week’s meeting, with one member seeking a 25 bp increase – see here. However, the forecast has changed significantly as a result of 1) a downward revision to first-quarter GDP growth, 2) very depressed consumer and producer confidence readings for June and 3) falls in share prices and short-term gilt yields. The model now suggests a 6-3 outcome, with three doves voting for a 25 bp cut.

These are testing times for the -ometer as well as the MPC. With inflation overshooting, it is possible the MPC will assign greater weight to price indicators and less weight to activity data and financial markets than on average over its 11-year history – the period over which the model has been estimated. If so, the 6-3 forecast will exaggerate the Committee’s easing bias – the 8-1 vote by the Sunday Times Shadow MPC may prove closer to the mark. However, any error will be used to improve the predictions for subsequent months in two ways: first, the model is reestimated monthly so the weights will be adjusted in light of the July outcome; secondly, the prior month’s vote is included as an input so a less dovish result in July will feed back into the forecast for August.