The Federal Reserve on Wednesday reduced its policy rate by 50 basis points to a range between 4.75% and 5% to protect full employment and preserve the soft landing it has achieved following a historic price shock.
The central bank also laid out a path of monetary policy that suggests additional 25 basis-point reductions at its November and December meetings.
Based on the Fed’s latest Summary of Economic Projections, the policy rate should end this year at 4.4% and 3.4% by the end of next year.
With the Fed forecasting that it intends to reduce the policy rate to 2.9%, or a full 2.5% below its new rate, such a reduction will unlock cash flows and unleash pent-up demand across the American economy over the next two years.
As elevated financing costs decline, American households and firms will grow more confident in their ability to invest and improve their economic prospects.
Looking ahead
The main takeaway from the Summary of Economic Projections is that the Federal Reserve has grown more confident of returning inflation to its 2% target.
The Fed reduced its expectations of the personal consumption expenditures index—its preferred gauge of inflation—to 2.3% by the end of this year, 2.1% next year and 2% in 2026.
The core PCE target is now forecast to decline to 2.6% by the end of this year, 2.2% next year and 2% in 2026.
This outlook is an indication of the Fed’s confidence that it has achieved price stability, which is allowing it to shift its focus to maintaining full employment.
Read more of RSM’s insights on Fed policy, the economy and the middle market.
The primary rationale cited by Federal Reserve Chairman Jerome Powell for the 50 basis-point rate cut was a slowing in the pace of hiring and a softer pace of growth in some areas of the economy.
Accordingly, the Fed changed its unemployment forecast to 4.4% this year and next year—a clear demonstration of intent and policy objective—and 4.3% in 2026.
The SEP implies that the Fed now operationally defines the non-accelerating inflation rate of unemployment as 4.2%.
Viewing price stability as having been restored, Fed officials are now focused on obtaining maximum sustainable employment. The Fed’s dual mandate from Congress is to achieve price stability and full employment.
Now, they intend to pursue the employment policy objective through less restrictive rates on the way back to the Fed’s projection of the terminal funds rate at 2.9%.
This is in line with our estimate of the terminal rate in the post-pandemic economy of at or around 3.25%.
But if inflation proves persistent, especially in the service sector should the economy continue to outperform, then the expected rate path could possibly see less than the 225 basis points of rate cuts implied by the forecast.
The Fed decreased its growth forecast for this year from 2.1% to 2%; retained its 2025, 2026 and 2027 estimate of 2%; and retained its forecast for a long-run growth rate of 1.8%.
Notably, the economy grew by 3.1% last year, expanded by that same rate through the middle of this year and, according to our tracker of gross domestic product and the one used by the Federal Reserve Bank of Atlanta, is on a 3% path for the current quarter.
Given that growth is outperforming expectations at a time when employment is slowing, that dynamic strongly suggests that improving productivity is the source of that growth.
We may see future upward revisions to the Fed’s growth projections, which may alter the rate path.
Policy directions
Our preferred model of the Federal Reserve’s reaction function implies an optimal policy rate of 3.45% given the current 2.5% PCE inflation rate and the Fed’s estimate of 4.2% for the non-accelerating inflation rate of unemployment, or NAIRU.
Those figures suggest that the Fed needs to quickly move its policy rate down by between 150 and 175 basis points in the near term as inflation eases.
Market pricing through the federal funds market following the publication of the policy decision implies that the Fed will most likely reduce its still-restrictive rate to near the current optimal rate by the second half of next year in contrast with the Fed forecast that suggests early 2026 before it reaches that neutral level.
The takeaway
The Federal Reserve took the first step in its new regime by cutting the policy rate by 50 basis points and presenting a forecast that points to a neutral rate of 2.9%.
The rationale of Wednesday’s cut and the Fed’s forecast is that the central bank intends to focus on maintaining full employment and creating the conditions to support the soft landing of the economy that past three years of difficult policy decisions has obtained.
