Opinion: The Fed’s path to normal

Don Davis

After much anticipation, the Federal Reserve lowered its target range for the federal funds rate by a half percentage point, or 50 basis points, in September. This action was followed by an additional 25 basis point rate cut at its November meeting.

The federal funds rate is the interest rate commercial banks charge each other for lending and borrowing their reserve balances overnight. It now stands at a target range of 4.5%-4.75%. With an additional 25 basis point reduction in short-term rates forecasted for 2024 and more cuts in 2025, it appears the Fed is recalibrating its monetary policy from restrictive toward normal.

Recall that the Fed began an aggressive rate-hiking strategy in March 2022 to combat rising inflation, which peaked at 9.1% as measured by the Consumer Price Index in June of that year. Fast forward to today: the CPI has fallen to 2.4%.

The Fed has a dual mandate of price stability, as measured by its 2% inflation target and maximum employment. It appears the Fed is confident enough with the continuing downward trend in inflation that it can focus on the U.S. labor market, which has experienced weakening since the start of the year.

The shift toward a less restrictive monetary policy suggests the Fed is attempting to find a neutral federal funds rate that neither accelerates nor restricts economic growth as it seeks to balance both inflation and employment.

The challenge now for the Fed is finding a neutral interest rate.

Using history as a guide, we provide a framework to identify the real federal funds rate, or an interest rate adjusted for inflation. To do this, we look at the federal funds rate relative to inflation, as measured by trailing CPI, which shows an average difference between the two measures of 91 basis points, or just under 1%, since 1970.

The high end of the federal funds rate is currently 5%, so subtracting the September CPI reading of 2.4% gives us a real federal funds rate of 2.6%. When adjusted for inflation, this suggests the real federal funds rate is currently 170 basis points higher than average. If we then factor the Fed’s forecast in short-term rate cuts through next year, this indicates the Fed could be approaching a neutral federal funds rate by late 2025 or early 2026.

While short-term rates may still have room for cuts, the longer end of the yield curve tells a different story.

It appears likely that future interest rate cuts have already been discounted on longer duration Treasury bonds. Historically, these yields typically don’t move materially unless we enter a significant economic slowdown. If this were to happen, the Fed would likely continue to lower rates, moving beyond a neutral rate to a position of accommodation.

With the Fed’s rate-cutting cycle now underway, it’s important to remember that capital markets often take time to adjust to them once they begin. For investors, it’s crucial to work with a wealth management team to assess your portfolio and ensure it aligns with your long-term financial goals in what continues to be a dynamic economic and market environment.

Don Davis is a senior portfolio manager with Commerce Trust. He can be reached at don.davis@commercebank.com.