The Federal Reserve has signaled that additional rate reductions may occur following the decrease on September 18, which lowered the rate from 5.25%-5.50% to 4.75%-5.00%. Their evaluation indicates that this rate still constrains economic activity. The Summary of Economic Projections (SEP) outlines a goal to bring the federal funds rate down to 2.9% within the next few years.
The SEP characterizes longer-term projections as the rate toward which economic variables would stabilize under suitable monetary policy while avoiding economic disruptions. These forecasts represent the midpoint of the anticipated appropriate target range for the federal funds rate at the conclusion of a designated calendar year or over the longer term. Current economic data suggest that the neutral federal funds rate is around 4.00%, if not higher.
This observation is reinforced by three significant economic indicators:
1. Economic growth has persisted amidst tighter monetary policy. The United States is experiencing full employment, inflation has eased without triggering a recession, and the labor market component of the Fed’s dual mandate has been fulfilled.
Inflation is nearing the Fed’s target of 2.0%, indicating that the economy could be aligned with a neutral federal funds rate. 2.
Fed indicates potential for further rate cuts
There seems to be an upward trend in productivity growth, reflecting a 2.7% increase year-on-year through Q2-2024, which is above the post-1940s average of 2.1%. Consequently, unit labor cost inflation decreased to 0.3% in Q2-2024, greatly aiding in the reduction of consumer price inflation. 3.
Enhanced productivity growth not only fosters real economic expansion but also helps to keep inflation in check. Increased productivity necessitates both higher nominal and real federal funds rates, making productivity growth a pivotal element in establishing the neutral interest rate.
Additional key considerations include the federal budget deficit, which has reached unprecedented levels amidst stable economic growth. Even so, inflation has eased, suggesting that substantial fiscal deficits have fueled economic growth and mitigated the recessionary effects of monetary policy tightening. This leads to the inference that the fiscal policy currently in place has elevated the neutral interest rate.
If the Federal Reserve proceeds with further cuts to the federal funds rate, it risks excessively stimulating an economy that may not require such measures, potentially causing a resurgence in both price and asset inflation rates, the latter already indicating a trend in the stock market.
