The Federal Reserve has indicated that more rate cuts are likely to follow the September 18 reduction from 5.25%-5.50% to 4.75%-5.00%. The rate remains restrictive, according to their assessment. The Summary of Economic Projections (SEP) suggests that the collective aim is to lower the federal funds rate to 2.9% over the next couple of years.
The SEP defines the longer-run projections as the rate to which variables would converge under appropriate monetary policy and without further economic shocks. These projections reflect the midpoint of the projected appropriate target range for the federal funds rate at the end of a specified calendar year or over the longer run. Based on current economic performance, it is estimated that the neutral federal funds rate is currently 4.00% and probably higher.
This is supported by three key economic trends:
1. The economy has continued to grow despite monetary tightening. The U.S. is at full employment, inflation has subsided without causing a recession, and the labor market part of the Fed’s dual mandate has been accomplished.
Inflation is fast approaching the Fed’s 2.0% target, demonstrating that the economy may be at a neutral federal funds rate. 2.
Fed suggests more rate cuts
Productivity growth appears to be on the rise, with a 2.7% year-over-year increase through Q2-2024, surpassing the post-1940s average of 2.1%. As a result, unit labor costs inflation decreased to 0.3% in Q2-2024, significantly contributing to lower consumer price inflation. 3.
Improved productivity growth also boosts real economic growth while containing inflation. Faster productivity growth necessitates higher nominal and real federal funds rates. Productivity growth may be one of the most crucial factors in determining the neutral interest rate.
Other significant factors include the federal budget deficit, which has been at a record high during a period of solid economic growth. Despite this, inflation has moderated, indicating that large fiscal deficits have boosted economic growth and offset the recessionary impact of monetary policy tightening. The conclusion is that the current administration’s fiscal policy has increased the neutral interest rate.
If the Fed continues to lower the federal funds rate, it could overstimulate an economy that doesn’t need it, possibly leading to a rebound in both price and asset inflation rates. The latter is already evident in the stock market.
