By Jeff Huther
ABA Data Bank
Now that the Fed has started to lower overnight interest rates, the question is how much lower will those rates go. An accurate but unsatisfying answer is that future rate cuts will depend on future changes in unemployment and inflation; as the Fed points out, it is data-dependent. While we can’t do anything to resolve the uncertainty of future data, we can frame how the Fed is likely to think about that data. In particular, the level of real interest rates will help shape the Fed’s views of where nominal short-term rates are headed.
The data
A weakening job market helped to justify the 50 basis point cut in the interest rate target range to 4.75 to 5.00 percent that was announced at the Sept. 18 Federal Open Market Committee meeting. While total employment has continued to rise, the pace of job creation has been uneven, and unemployment has come off of its post-pandemic lows (see figure 1). If employment were the Fed’s only concern, we could be assured of continued interest rate cuts at successive future Fed meetings. But the Fed’s responsibility also to keep inflation in check via its dual mandate of price stability and maximum sustainable employment suggests caution in forecasting rate cuts.
Prices continue to rise at a somewhat faster pace than the Fed’s 2 percent target (see figure 2). The September 18 rate cut is evidence that Fed officials believe that inflation will continue to moderate (or, at least, not accelerate). Relative weights in the Fed’s reaction function will shift again if unemployment does not increase at pace in the coming months as it did earlier in 2024 and inflation remains around 2.5 percent.
The views of Fed officials are shaped in part by “real” interest rates — that is, by subtracting the rate of inflation from nominal interest rates. A nominal interest rate of, say, 5 percent can restrict or accommodate economic growth depending on the rate of inflation. Over the decade between the 2008-09 financial crisis and the COVID crisis, real interest rates were mostly negative, a deliberate and highly accommodative policy stance to offset the effects of what (we hope) was a once-in-a-lifetime financial crisis.
High inflation following the pandemic led to another round of highly accommodative real interest rates even as the Fed began raising nominal interest rates. The slower pace of inflation more recently has led to positive real interest rates even though the nominal short rates were unchanged from the July 2023 FOMC meeting to the Sept. 2024 FOMC meeting.
To help dimension the range of the Fed’s interest rate goals, consider Fed Chairman Jerome Powell’s characterization of the current combination of inflation and the Fed’s nominal interest rates, or real interest rates slightly above 2 percent, as “restrictive” (see figure 3). The negative real rates following the financial crisis and the pandemic are unlikely to be seen as appropriate in responding to less extreme economic slowdowns. That is, recent episodes of highly accommodative real interest rates are unlikely to be repeated in the absence of another massive economic shock.
We can put boundaries on our projections of nominal short-term interest rates by combining our views that current real rates are restrictive and negative real rates are only appropriate in extraordinary circumstances. While additional nominal rate cuts are likely, cuts that take nominal short-term interest rates below the rate of inflation are highly unlikely. Since inflation is currently running at 2.5 percent, we can be reasonably confident that the Fed’s nominal interest rate target will be above that.
So, where are the Fed’s target interest rates going? The FOMC provides individual committee member assessments of interest rates for each of the next three years. Those assessments currently suggest that committee members expect to cut rates another quarter to half of 1 percent by year-end, although the September employment report may put those cuts in doubt. Current projections of nominal interest rates out to 2026 suggest that the FOMC is aiming for a real interest rate around 1 percent, assuming a 2 percent inflation rate. If inflation deviates from the official Fed target, keeping this real rate “target” in mind can provide a useful guide as to how low nominal rates will ultimately go.
For additional research and analysis from the ABA’s Office of the Chief Economist, please see the OCE website.
