How much will the Fed cut interest rates?

Wondering what’s in store for interest rates?

Since July 2023, the Federal Reserve has kept the federal-funds rate at a target range of 5.25% to 5.50%, far above the near-zero levels averaged since the 2008 financial crisis. But we expect Fed officials to deliver hefty cuts over the next two years and bring the federal-funds rate to 2.00% to 2.25% by year-end 2026. Longer-term interest rates, including the 30-year mortgage rate, are due to fall as well.

The ongoing downtrend in inflation is enabling a pivot in monetary policy, and the recent uptick in unemployment is impelling the Fed to act sooner rather than later. We expect three rate cuts in 2024 of 25 basis points each, starting in September.

We expect inflation in 2025 and 2026 to come in below the Fed’s 2% target. Meanwhile, we expect gross domestic product growth to weaken to 1.5% in 2025 from 2.6% in 2024, with unemployment remaining slightly elevated at 4.5% in 2025 and 4.4% in 2026. All of this will call for rate cutting well into 2026. We expect the 10-year Treasury yield to drop to our long-run expectation of 3% by 2027, down from 3.7% as of September 2024. For the full details, see our US Economic Outlook.

Why did the Federal Reserve hike interest rates in 2022 and 2023?

Since 2022, the Fed has been engaged in an all-out struggle against high inflation.

Inflation peaked in 2022 at 6.5% (using the personal consumption expenditures price index), the highest in 40 years (since 1981). The Fed responded proportionately. From March 2022 to July 2023, the Fed increased the federal-funds rate by 5.25 percentage points, marking the largest and fastest rate hike in 40 years.

The Fed has also engaged in “quantitative tightening”—selling off about $1.8 trillion from its long-term securities portfolio since June 2022. That’s exerted upward pressure on longer-term interest rates (think the 10-year Treasury yield), though the exact impact is hard to quantify.

The United States (and many other countries) experienced a decade of low interest rates after the 2008 global financial crisis and the Great Recession.

The 10-year Treasury yield averaged 2.4% from 2010 to 2019, compared with 3.7% today. The federal-funds rate was near zero much of the time, averaging 0.6% from 2010 to 2019.

We did see interest rates tick up toward the end of the decade, but only slightly (the 10-year averaged 2.5% from 2017 to 2019, and the federal-funds rate averaged 1.7%). During the pandemic in 2020, interest rates temporarily collapsed, reflecting the depressed state of the economy.

How the economy has responded to higher interest rates

Higher interest rates have meant higher borrowing costs for consumers and businesses. For example, the 30-year mortgage rate stands at about 6.2% as of September 2024, a massive jump compared with the 3.0% average in 2021 and far above the 4.2% average in the prepandemic years (2017 to 2019)

Higher interest rates are designed to slow down spending in interest-rate-sensitive sectors like housing. This cools off the broader economy, helping achieve the Fed’s goal of reducing inflation.

Yet, the US economy proved more resilient to the impact of higher rates than expected in 2023. Widespread fears of a recession did not play out. Housing activity fell sharply, but much of the rest of the economy has been unscathed.

The impact of the surge in the federal-funds rate has also been somewhat cushioned by the inversion of the yield curve, where short-term bond rates (such as the fed-funds rate) are higher than long-term bond rates (such as the 10-year Treasury yield).

Recall that the fed-funds rate is under the direct control of the Federal Reserve, allowing the Fed to control short-term risk-free interest rates. Longer-run interest rates are influenced by the Fed but only indirectly.

Contrary to much commentary in the financial press, yield-curve inversion is not contractionary. There is a historical correlation between yield-curve inversions and recessions, but the statistical significance is weak using cross-country evidence.

From a causal perspective, an inverted yield curve actually stimulates the economy compared with a flat yield curve (holding short rates fixed) because it means lower borrowing rates on long-term debt. Because the yield curve has inverted so much, the Fed has been forced to hike the federal-funds rate more than it would have otherwise to sufficiently cool off the economy.

Of course, even while the Fed failed to cool down the demand side of the economy in 2023 very much, inflation ended up falling anyway because of supply-side improvement, which is unrelated to monetary policy.

When will the Fed lower interest rates?

We expect the Fed to start cutting rates beginning with the Federal Open Market Committee’s September 2024 meeting.

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.

Interest-rate forecast. We project the federal-funds rate target range to fall from 5.25%-5.50% currently to 4.50%-4.75% at the end of 2024, 3.00%-3.25% at the end of 2025, and 2.00%-2.25% by the end of 2026, after which the Fed will be done cutting. Likewise, we expect the 10-year Treasury yield to move down to an average of 3.0% in 2027 from its current yield of 3.7%. We expect the 30-year mortgage rate to fall to 4.75% in 2027 from an average of 6.75% in 2024.
Inflation forecast. It looks like inflation will return to normal without a recession. We expect inflation to fall from 3.7% in 2023 to 2.4% in 2024 and an average rate of 1.8% over 2025-28, dipping slightly below the Fed’s 2.0% target. The continual downtrend in inflation will be owed greatly to the unwinding of price spikes as supply constraints ease and as the pace of economic growth slows.

Inflation reports showing falling rates over the past year have defied the predictions of those in the stagflation camp, who thought that a deep economic slump would be needed to eradicate entrenched inflation. Instead, the inflation-GDP trade-off has been very kind.

We did see an uptick in inflation in January and February 2024, which ruled out cuts in the first half of the year. But since then, the inflation news has been much more favorable to rate cuts. Meanwhile, the increase in unemployment is adding urgency for the Fed to cut rates. We’re not as worried about the uptick in unemployment as some others, but we do think it makes sense for the Fed to begin cutting rates from a risk-management perspective.

Ultimately, we think the economy needs much lower interest rates to sustain a healthy growth rate. The full effects if interest rates were to remain at today’s high levels have not played out. For example, many borrowers (from home mortgages to corporate bonds) remain locked into low rates and thus temporarily shielded from the burden of high rates. But as that debt rolls over, more and more consumers and businesses become exposed to the burden of high interest rates.

Home mortgage affordability, gauged by the ratio of the median home mortgage payment to household income, is at its worst level since the mid-2000s’ housing bubble. We think most homebuyers are placated by the promise of refinancing at lower rates a few years down the line. But fulfilling that promise (and preventing a further deterioration in the housing market) will require the Fed to cut aggressively.

How do our interest-rate forecasts compare with others?

With the continued positive news on inflation as well as the worrying labor market data, market expectations (according to federal-funds futures) have greatly shifted toward our expectations of aggressive Fed rate cuts. At year-end 2025, market expectations are for a federal-funds rate at 2.75%-3.00%, about in line with our forecast of 3.00%-3.25%.

In fact, for late 2024 and early 2025, markets are now expecting even a faster pace of rate cutting than we are. Markets are baking in expectations of multiple 50-basis-point per meeting rate cuts.

But we think the Fed is likely to stick to cutting by 25 basis points per meeting. With bond yields falling in tandem with greater expectations of rate cuts, the impact of monetary policy loosening will be somewhat front-loaded. That reduces the Fed’s need to hurry.

How will Fed-Funds Rate cuts affect the economy?

We expect that GDP growth will trough in 2025 but reaccelerate in 2026 and 2027 on the back of Fed rate cuts. The resolution of supply constraints should facilitate an acceleration in growth without inflation becoming a concern again.

We expect a cumulative 200 basis points more real GDP growth through 2028 than the consensus does. Consensus remains overly pessimistic on the recovery in the labor supply and has generally overreacted to near-term headwinds, in our view.

How does inflation affect interest-rate projections?

We expect inflation to fall to normal levels after having peaked at 6.5% 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. Still, supply chains are healing as demand normalizes and capacity catches up. These factors drove inflation down to 3.7% in 2023, and we expect the rate to fall further to 2.4% in 2024, with an average of 1.9% from 2024 to 2028.

We’re more optimistic about 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.

Where will interest rates be in 2025 and beyond?

In the short run from 2024 to 2026, our interest-rate forecast is centered on the Fed’s mission and attempts to smooth out economic cycles. The Fed seeks to minimize the output gap (the deviation of GDP from its maximum sustainable level) while keeping inflation low and stable. When the economy is overheated (that is, the output gap is positive and inflation is high), as today, then the Fed seeks to hike interest 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 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, and they haven’t gone away. Regardless of what happens in the next few years, we expect interest rates to ultimately settle back down at the low levels prevailing before the pandemic. The low interest-rate regime will resume once the dust settles from the pandemic’s economic volatility.

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.