The Federal Reserve signaled at its meeting on Wednesday that it is done raising its policy rate and is poised to reduce it by 75 basis points next year, with more cuts after that.
The Fed now projects that the federal funds rate will be reduced by 250 basis points by the end of 2026.
The Fed also reduced its inflation forecast for next year to 2.8% from 3.3%, and to 2.4% from 2.5% for 2025, which both support the notable reductions in interest rates that the Summary of Economic Projections implies.
The Fed now projects that the federal funds rate will be reduced by 250 basis points by the end of 2026 and implies a policy rate in the long run at 2.5%.
In making these projections, the central bank took a large step toward bringing its outlook in line with market expectations, which before the meeting held that the Fed would make 100 basis points of rate cuts starting in June—in line with RSM’s forecast.
It is critical that the Fed move to stabilize real rates. Even when the federal funds rate holds steady, as it has in recent months, real rates in the market can fluctuate and lead to a further tightening of financial conditions.
To bring down real rates, the Fed will need to cuts its policy rate next year, which is implied in its new forecast. Federal Reserve Chairman Jerome Powell, though, was offered the chance to state this clearly and he avoided doing so. There is a long way to go before policymakers and investors can obtain a more precise identification of the policy path for next year and for 2025..
In our estimation, the Fed put forward a constructive statement and forecast that strongly support RSM’s core baseline forecast of a soft landing and sustained full employment next year and in 2025.
Read more of RSM’s insights on the economy and the middle market.
In addition, the risks looming in 2025—which include the maturity wall of corporate debt that will need to be rolled over and the expiration the tax cuts enacted in 2017—will most likely result in a quicker pace of rate cuts than the forecast implies.
The statement
The Federal Open Market Committee’s new policy statement noted both an easing in inflation and a slower pace of economic expansion from the strong pace in the third quarter. Those were the only major changes to the statement.
For the third straight meeting, the Fed held its policy rate in a range between 5.25% and 5.5% and signaled to investors, policymakers and the public that it is done with its rate hike campaign.
The statement was careful to note that “the Committee will continue to assess additional information and its implications for monetary policy. In determining the extent of any additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
From our vantage point, this points toward a pivot in policy as the Fed moves to reduce a sufficiently restrictive policy rate as inflation eases toward the forecast of 2.4% in the core personal consumption expenditures index by the end of 2025.
Dot plot
The Fed’s forecast of its policy rate, or its dot plot, shows a median of 4.6% in 2024, 3.6% in 2025 and 2.9% in 2026. The long-run policy rate stands at 2.5%. This forecast indicates that the ultimate destination of the Fed’s policy includes 300 basis points and a move to 2.5% in the policy rate.
We think that this may be somewhat overoptimistic given what we think will be a stronger pace of economic growth and modestly higher inflation which will result in a 2.5% to 3% inflation target and a Fed neutral rate of 3%.
Whatever the case, interest rates are coming down, the term spectrum along the Treasury curve is likely to return from its inversion over the next two years assuming a positive upward slope bolsters net interest margins inside the financial sector and boosts demand for financing.
Summary of Economic Projections
The Summary of Economic Projections strongly supports the idea that the economy is likely to avoid a recession and that rate cuts are coming next year. In addition to the Fed’s projections of higher growth and lower inflation, the central bank is projecting a long-run unemployment rate of 4.1%, which by any metric implies full employment inside the American economy.
The takeaway
The major takeaway from the December policy meeting is that the Federal Reserve is forecasting a soft landing and full employment, and intends to reduce its policy rate by at least 75 basis points next year to support the expanding economy. From our vantage point, that is about the best holiday gift a central banker can bestow upon the investment community, policymakers and the public.
