The Fed is wrong about how low interest rates will go: Bill Dudley

Markets and the Fed now agree about 2024: Futures prices are consistent with officials’ median estimate of 75 basis points of cuts in the federal funds rate. Yet forecasts for the next few years diverge. Futures indicate that short-term interest rates will bottom out at about 3.75% in 2027, while the median forecast among members of the policy-making Federal Open Market Committee is 2.6% — more than 100 basis points lower.

Why the difference? I see two reasons. First, market participants expect average inflation to be higher than the Fed’s 2% target. This makes sense, because the target is asymmetric: The central bank is committed to offsetting downside misses with comparable misses to the upside, but not the other way around. Chair Jerome Powell never talks about pushing inflation below 2% to offset the high readings of recent years, and official projections don’t indicate any such intention. As a result, average inflation should exceed 2%. The greater the volatility of inflation over time, the larger the divergence should be.

Second, the market appears to have a higher estimate of the neutral federal funds rate — the level, known as r*, that neither stimulates nor restrains growth. Various developments support this. For one, the economy has remained strong even as the Fed has increased its target rate by 525 basis points, suggesting that the current level of 5.25% to 5.50% might not be as restrictive as officials expected. Increased productivity growth, together with the AI boom, should stimulate greater investment and hence nudge equilibrium interest rates upward. Declining savings push in the same direction: The federal government is running vast budget deficits, while soaring asset prices have boosted household wealth, leading the personal savings rate to decline to 3.6% of disposable income, from an average of 5.7% in the decade following the 2008 financial crisis.

Fed officials have clung to the notion that the neutral rate remains depressed. New York Fed President John Williams has referred to the Holsten-Laubach-Williams model that he helped develop, which estimates r* at less than 1% (in real, inflation-adjusted terms). Powell has emphasized that takes effect with long and variable lags, implying that past have yet to be fully felt. He has argued that some of the economy’s strength reflects a boost from the easing of supply-chain constraints, an impulse that will inevitably dissipate. At his March press conference, he resisted the notion that the recent easing of suggests the need for higher short-term rates to compensate.

Again, I’m with the market, largely due to the strength of the economy and the significant easing in financial conditions. Notably, Fed officials have started moving in the market’s direction: In March, the FOMC’s median estimate of r* was 0.6%, up from 0.5% in December. And the range of estimates is skewed even higher.

Taken together, higher average inflation — say, 2.5% — and a neutral rate of 1% to 1.5% would imply a long-term federal funds rate of 3.5% to 4.0%. So while the Fed’s projections for 2024 look likely to be more accurate than the market’s at the start of the year, this time around it’s the central bank, not the market, that will probably have to adjust.