Financial markets and the US Federal Reserve remain in disagreement on a subject crucial to asset prices and economic growth: how low interest rates will eventually go.
Betting against the Fed is a fraught endeavor. Nonetheless, in this case I think the market is right.
Markets and the Fed now agree about 2024: Futures prices are consistent with officials’ median estimate of 75 basis points of cuts in the federal funds rate. Yet forecasts for the next few years diverge. Futures indicate that short-term interest rates will bottom out at about 3.75% in 2027, while the median forecast among members of the policy-making Federal Open Market Committee is 2.6% — more than 100 basis points lower.
Why the difference? I see two reasons. First, market participants expect average inflation to be higher than the Fed’s 2% target. This makes sense, because the target is asymmetric: The central bank is committed to offsetting downside misses with comparable misses to the upside, but not the other way around. Chair Jerome Powell never talks about pushing inflation below 2% to offset the high readings of recent years, and official projections don’t indicate any such intention. As a result, average inflation should exceed 2%. The greater the volatility of inflation over time, the larger the divergence should be.
Second, the market appears to have a higher estimate of the neutral federal funds rate — the level, known as r*, that neither stimulates nor restrains growth. Various developments support this. For one, the economy has remained strong even as the Fed has increased its target rate by 525 basis points, suggesting that the current level of 5.25% to 5.50% might not be as restrictive as officials expected. Increased productivity growth, together with the AI boom, should stimulate greater investment and hence nudge equilibrium interest rates upward. Declining savings push in the same direction: The federal government is running vast budget deficits, while soaring asset prices have boosted household wealth, leading the personal savings rate to decline to 3.6% of disposable income, from an average of 5.7% in the decade following the 2008 financial crisis.
