When will the Fed start cutting rates? (2024)

Do you have doubts about what interest rates await you?

Since July 2023, the Federal Reserve has kept the fed funds rate at a target range of 5.25% to 5.50%, well above typical levels over the past decade. But we expect the first federal funds rate cut to occur in May or June 2024, bringing rates down to 4.00% to 4.25% by the end of 2024.

We expect the Fed to continue austerity until the end of 2025, ultimately causing the Fed funds rate to fall by more than 300 basis points. Our long-term expectation for the yield on ten-year government bonds is 2.75%, which is significantly lower than the current interest rate of 4.30% per year. February 23, 2024.

In our latestEconomic prospectswe describe that falling inflation will make this change possible in early 2024. A slowdown in gross domestic product growth (and a small increase in unemployment) in 2024 will be another reason for the Fed to cut spending.

Why have interest rates risen so sharply in 2022 and 2023?

The Fed has been raising rates since early 2022 to stem high inflation. From March 2022 to July 2023, the Fed raised the Fed rate by 5 percentage points, marking the largest and fastest rate increase in four decades. The Fed has also engaged in “quantitative tightening,” selling about $1.4 trillion from its long-term securities portfolio since June 2022.

The US (and many other countries) had experienced a decade of low interest rates following the 2008 global financial crisis and the Great Recession. Ten-year government bond yields averaged 2.4% between 2010 and 2019, compared to 4.3% today. The federal funds rate was near zero most of the time, averaging 0.6% between 2010 and 2019. We saw rates rise in the years before the pandemic, but only slightly (the 10-year rate averaged 2.5% between 2017 and 2019, and the federal funds rate averages 1.7%.

Now that interest rates have reached levels not seen since the mid-2000s, many are wondering if we have moved to a new regime of higher interest rates.

Higher interest rates have led to higher borrowing costs for consumers and businesses. The 30-year mortgage rate is about 6.9%, a huge increase from the 2021 average of 3.0% and well above the 4.2% average in the pre-pandemic years (2017 to 2019). Mortgage interest rates peaked at 7.8% in November 2023, the highest in more than twenty years.

Higher interest rates are intended to curb spending in interest-rate-sensitive sectors such as housing. This cools the broader economy and helps achieve the Fed's goal of reducing inflation.

However, the US economy proved more resilient to the impact of higher-than-expected interest rates in 2023. Widespread fears of a recession did not materialize. Housing activity fell sharply, but much of the rest of the economy was unscathed.

The effect of the increase in the federal funds rate is also somewhat mitigated by the inversion of the yield curve. Keep in mind that the Fed Funds rate is under the direct control of the Federal Reserve, which allows the Fed to control the short-term risk-free rate. Long-term interest rates are influenced by the Fed, but only indirectly. Yield curve inversion refers to a situation in which short-term interest rates (such as the Fed Funds rate) rise above long-term interest rates (such as 10-year Treasury yields).

Contrary to much commentary in the financial press, the inversion of the yield curve is not contractual. There is a historical link between yield curve inversions and recessions, but statistical significance is weak based on data from multiple countries. From a causal perspective, an inverted yield curve actually stimulates the economy compared to a flat yield curve (where short-term interest rates remain fixed) because it means lower interest rates on long-term debt. Because the yield curve has inverted so much, the Fed is forced to raise the Fed rate more than would otherwise be necessary to sufficiently cool the economy.

Of course, even if the Fed failed to significantly cool the demand side of the economy in 2023, inflation still fell due to an improvement on the supply side unrelated to monetary policy.

When will interest rates fall?

We expect the Fed to start cutting rates from its May 2024 meeting.

The Fed will proceed with monetary easinginflation fallsachieving the 2% target and the need to support economic growth is becoming a major problem.

1) Interest rate forecast.We expect the Federal Funds Rate target to decline from 5.25% to 5.50% currently to 4.00% to 4.25% by the end of 2024, to 2.25% to 2.50% by the end of 2025 and to 1.75% to 2.00% in the first half of 2026, after which the Fed will stop cutting spending. Similarly, we expect the yield on ten-year government bonds to fall from the current 4.30% to 2.75% in 2025. We expect the 30-year mortgage interest rate to fall from an average of 6.8% in 2023 to 5.0% in 2025.

2) Inflation forecast.Inflation appears to be returning to normal, without a recession. We expect inflation to fall from 3.7% in 2023 to an average rate of 1.9% in 2024-28, slightly below the Fed's target of 2.0%. The continued downward trend in inflation will largely be due to the dissipation of price increases as supply constraints ease and the pace of economic growth slows.

The fall in inflation over the past year has defied the predictions of those in the stagflation camp, who believed that a deep economic slowdown would be needed to eradicate stuck inflation. Instead, the trade-off between inflation and GDP has been very friendly.

Admittedly, there is still some uncertainty about whether the Fed will cut rates by the middle of this year. This depends on Fed members' own subjective assessment of whether progress on inflation is enough to begin cutting interest rates. But even assuming the Fed doesn't cut rates in May, we believe inflation data in the second half of the year will leave no doubt about whether it is appropriate to cut rates.

As long as the Fed is allowed to move to easing in 2024, GDP should avoid a major downturn and start to accelerate in 2025 and 2026.

Residential construction is the most interest-rate sensitive main component of GDP, and we expect a further decline in the number of homes by 6% in 2024. The higher mortgage interest rates in combination with the previous increase in house prices means that house prices have reached their worst level since 2007. are necessary to prevent a deeper and longer-lasting downturn in the housing market.

Why don't we agree with other investors (and the Fed) on how quickly rates will fall?

The near-unanimous view now is that the Fed is done raising rates, but there is still a lot of debate about when and how rates will be cut.

Markets have moved closer to our view in recent months on good inflation news. The market now agrees with us that the Fed will make five interest rate cuts until the end of 2024.

Looking beyond 2024, there is still some discrepancy between our views and the market. We expect the Fed Funds rate to be more than 150 basis points below market forecasts by mid-2026.

We believe that the Fed will attempt to cut interest rates from current “restrictive” levels to a more neutral stance in early 2024, as victory over inflation comes into view. Economic weakness in mid-to-late 2024 will prompt the Fed to pick up the pace. In 2025, inflation will still be below target and unemployment will be slightly high, leading to further cuts.

We expect inflation to fall faster than consensus, which is why we expect the Fed to ultimately cut rates more aggressively than it currently expects. Similarly, other investors now seem too pessimistic about how quickly inflation will fall.

Bold interest rate cuts will boost GDP growth

We expect GDP growth to accelerate in the second half of 2025 as the Fed moves toward easing, with full-year growth rates peaking in 2026 and 2027.supply restrictionsshould facilitate an acceleration of growth without inflation becoming a problem again.

We expect cumulative growth of almost 200 basis points more real GDP than the consensus until 2028. The consensus remains overly pessimistic about the labor supply recovery and, in our view, has generally overreacted to short-term headwinds.

Resolving supply constraints and tightening the Fed will suppress inflation

We expect inflation to decline to normal levels, after peaking at 6.5% in 2022. We still believe that most sources of high inflation since the start of the pandemic will decline in the coming years (and even will decrease in effect). This includes energy, cars and other sustainable goods. But supply chains are recovering as demand normalizes and capacity catches up. These factors have pushed inflation down to 3.8% in 2023, and we expect inflation to fall further to 2.0% in 2024, with an average of 1.9% between 2024 and 2028.

We are more optimistic that inflation will fall than the consensus. We believe the consensus underestimates the deflationary momentum that sectors such as energy and renewables are likely to provide in the coming years as the pandemic's disruptions fade.

US interest rate forecast: what we see in the future

In the short term, our interest rate forecasts focus on the Fed and its efforts to smooth economic cycles. The Fed aims to minimize the output gap (GDP's deviation from 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 it is now, the Fed tries to raise rates to slow growth.

But our long-term interest rate projections are driven more by secular trends than by the Fed. Instead, interest rates are determined by underlying trends in the economy, such as an aging population, slower productivity growth and greater economic inequality. These forces have been working to lower interest rates in the US and other major economies for decades, and they have not gone away. Regardless of what happens in the coming years, we expect interest rates to eventually return to their pre-pandemic low levels. The low interest rate regime will resume once the dust settles from the economic volatility of the pandemic.

That is why our interest rate forecast includes the expectation that these rates will remain lower for a longer period. Even if we are wrong in our short-term view that the Fed's war on inflation will be short-lived, our long-term view on interest rates remains valid. Our long-term analysis is detailed in our.

This article was authored by Emelia Fredlick and Yuyang Zhang.