When Will the Fed Start Cutting Interest Rates?
Our latest economic forecast for interest rates, inflation, and GDP growth.
Our latest economic forecast for interest rates, inflation, and GDP growth.
Wondering what’s in store for interest rates?
Although the Federal Reserve continues its campaign of hiking interest rates—and economic turbulence persists—our long-term optimism about gross domestic product and inflation remains largely unchanged.
In our latest Economic Outlook, we detail that although a recession in the next 12 months remains a serious possibility (about 25%), it should be short-lived if it occurs. Once the Fed wins the war against inflation, it will shift to cutting interest rates in order to get the economy moving again.
The Fed has pushed interest rates higher for more than a year in order to quash high inflation. It’s done this by hiking the federal-funds rate and other measures, which has driven interest rates to levels not seen since the late 2000s, before the global financial crisis.
The United States (and many other countries) had experienced a decade of low interest rates after the 2008 crisis and the Great Recession, but many investors are now wondering whether that era has ended for good.
Higher interest rates have meant higher borrowing costs for consumers and businesses. The 30-year mortgage rate reached 7% at one point in November 2022, the highest in over 20 years. This is causing a slowdown in spending in housing and other sectors of the economy. This is by design—the Fed must rein in spending in order to bring inflation down.
One reason that interest rates have risen much further than most forecasters (including us) anticipated is that the U.S. economy has proved more resilient to the impact of higher rates than expected. Housing activity has fallen sharply, but much of the rest of the economy seems unscathed. We think that households’ excess savings and other factors are temporarily cushioning the hit from higher interest rates. In 2023, we expect the impact of rate hikes to be felt more strongly in other parts of the U.S. economy.
First, we expect the Fed to pause its rate hikes by summer 2023. Then starting around the end of 2023, we expect the Fed to begin cutting the federal-funds rate.
The Fed will pivot to monetary easing as inflation falls back to its 2% target and the need to shore up economic growth becomes a top concern.
1) Interest-rate forecast. We project a year-end 2023 federal-funds rate of 4.75%, falling to 2% by the end of 2024. Further out, our 2026 and long-run projection for the fed-funds rate and 10-year Treasury yield are 1.75% and 2.75%, respectively. We do, however, expect interest rates to dip below these levels in 2025 and 2026 as monetary policy leans accommodative.
2) Inflation forecast. We project price pressures to swing from inflationary to deflationary by 2023, owing greatly to the unwinding of price spikes caused by supply constraints in durables, energy, and other areas. This will make the Fed’s job of curtailing inflation much easier. In fact, we think the Fed will overshoot its goal with inflation averaging 1.9% over 2023-26.
The inflation analysis is critical to our near-term projections for GDP and interest rates. If inflation becomes much more entrenched, the Fed will have to engineer a sharp short-run recession by hiking interest rates much higher than we expect.
As long as the Fed is allowed to shift to easing by the end of 2023, GDP should avoid a large downturn and start to accelerate in 2024 and 2025. Housing, which is the most interest-rate-sensitive major component of the GDP, will drive much of the fluctuation in GDP growth. Lower rates in 2024 and 2025 will be needed to improve housing affordability via lower mortgage rates and thereby resuscitate demand in an ailing housing market.
For investors, the Fed’s pivot should provide welcome relief. Rising interest rates played a key role in the selloff in both stocks and bonds in 2022. Bonds will certainly rally if yields fall in line with our forecasts for the next five years. And while not guaranteed, we expect that falling interest rates would likely also lift stock prices.
Our expected path for the federal-funds rate is below what other investors are expecting, as gauged by the federal-funds futures market. The Fed’s own projections are about in line with the futures market. The difference starts small, but by the end of 2024, we expect a federal-funds rate about 2 percentage points lower than the market and the Fed.
Why do we think we know what the Fed will do—better than the Fed itself? Ultimately, the Fed will adjust to the incoming data. At many points in the past 10 years (when the Fed first started issuing multiyear projections for the federal-funds rate), the Fed has veered from its initial forecasts owing to shifts in the data.
We expect inflation to come down quicker than the Fed expects, which is why we expect the Fed to eventually cut interest rates more aggressively than it currently projects. Likewise, other investors now appear too pessimistic on how quickly inflation will fall.
We expect that GDP growth will bounce back starting in 2024 as the Fed pivots to easing. The resolution of supply constraints should facilitate an acceleration in growth without inflation becoming a concern again.
We expect a cumulative 3%-4% more real GDP growth through 2027 than consensus does. Consensus remains overly pessimistic on the recovery in the labor supply and has overreacted to near-term productivity headwinds, in our view.
We expect inflation to fall to normal levels after peaking at 6.2% in 2022. We still think most of the sources of high inflation since the start of the pandemic will abate (and even unwind in impact) over the next few years. This includes energy, autos, and other durables. Aggressive capacity expansion across many areas could turn widespread shortages into gluts within a few years. Combining these factors with monetary policy tightening, we expect inflation to average just 1.9% over 2023-27.
We’re more optimistic on inflation coming down than consensus. We think consensus underrates the deflationary impulse likely to be provided by industries like energy and durable goods in coming years, as pandemic-era disruptions fade.
In the short run, our interest-rate forecast is centered on the Fed and its attempt to smooth out economic cycles. The Fed seeks to minimize the output gap (the deviation of GDP with its maximum sustainable level) while keeping inflation low and stable. When the economy is overheated (the output gap is positive and inflation is high), as today, then the Fed seeks to hike interest rates to slow growth.
In the long run, the Fed largely disappears from the picture. Instead, interest rates are determined by underlying currents in the economy, like aging demographics, slower productivity growth, and higher economic inequality. These forces have acted to push down interest rates in the United States and other major economies for decades, by creating an excess of savings over investment. In other words, the natural rate of interest has shifted downward. These long-term drivers of low interest rates haven’t gone away and will return to the fore once the dust settles from the pandemic.
For this reason, our interest-rate forecast includes the expectation that these rates will stay lower for longer. Even if we’re wrong in our near-term view that the Fed’s war against inflation will be a short one, our long-term view on interest rates remains valid. Our long-term analysis was detailed in our 2022 U.S. Interest Rate & Inflation Forecast.
A version of this article was published on Oct. 21, 2022.