ORLANDO, Florida, Sept 18 (Askume) – Beyond the Federal Reserve’s immediate headline-grabbing 50 basis point rate cut, policymakers also revised the ultimate target for the federal funds rate and the time it will take to reach that target.
Overall, the Fed said on Wednesday that it would remove its restrictive policy stance earlier than previously indicated, and the final “neutral” policy level would be slightly higher.
The Fed is essentially signaling a slightly faster and narrower easing cycle. The first part may point to concerns about the labor market or the economy, but the second part shows that officials are becoming increasingly confident in the economy’s resilience.
Officials hope that bold and prompt action from a position of relative strength can best protect the labor market and economic growth and, hopefully, lift the economy out of recession.
In short, the Fed believes a “soft landing” is still within reach.
This may explain why bond yields rose and stocks fell on Wednesday, as some optimistic hopes of lower long-term interest rates were dashed.
Too many restrictions
The Federal Reserve lowered the federal funds target range to 4.75-5.00%, with a midpoint of 4.875%. It also raised its average forecast for the long-term federal funds rate to 2.9% from June’s 2.8%. While not much has changed, 2.9% was the highest level since 2018 and was well above December’s 2.5%, which had seen little change in years.
Moreover, according to the Federal Reserve’s official estimates, the policy rate will fall to 2.9% in just two years, by the end of 2026. Recent staff economic forecasts indicate that the long-term federal funds rate, or neutral rate, will not be reached for at least three years.
The Fed has implicitly acknowledged that policy will remain in restrictive territory above “neutral” for a considerable period of time. This is the essence of the “long-term high” interest rate outlook.
In theory, however, a higher expected “final” rate would reduce the number of policy barriers that must be removed before policy becomes persuasive.
Most analysts agree that policy has been too restrictive for some time. In a research note published earlier this month, Fed economists estimated that real interest rates in March were about 1.15 percentage points above the natural rate, “about the same level as before the 2001 and 2008 recessions.”
The real federal funds rate, adjusted for annual consumer inflation, was the highest in 17 years. Meanwhile, JPMorgan strategists noted this week that policy is actually tighter than at any time in the past 30 years, compared to the “R-star” estimate.
R star, floating in the sky
“R-star” is the real interest rate that neither stimulates nor inhibits economic activity when the economy is at full employment. Assuming that the Fed’s 2% inflation target is achieved and taking into account the Fed’s forecast of a new long-term policy rate of 2.9%, Fed officials expect the R-star rate to be about 0.9%.
The rockstar is often ignored or ridiculed because it’s a theoretical, unknown number that’s always changing. But as New York Fed President John Williams said in July, it’s explicitly or implicitly “at the heart of any macroeconomic model or framework one could imagine.”
Investors cannot ignore this.
Considering that the new federal funds midpoint rate is 4.875% and policymakers’ new long-term forecast is 2.9%, it is reasonable to anticipate that Fed policy will now tighten by about 200 basis points.
In other words, the federal funds rate will not be considered neutral until it is lowered by 200 basis points, as the Fed has indicated it intends to do by the end of 2026.
That’s not a sure thing, and Chairman Powell stressed that the Fed’s upcoming decisions will be data-driven and based on each meeting. Investors will certainly make judgements, but the Fed said on Wednesday that it would not stay behind the curve and was confident of a soft landing.
(The views expressed in this article are those of the author, a Askume columnist.)
The views expressed are those of the author. They do not reflect the views of Askume News, which is committed to integrity, independence and non-partisanship under the principles of trust.
