The Federal Reserve maintained its policy rate in a range between 5.25% and 5.5% on Wednesday while revisions to its Summary of Economic Projections strongly imply that the central bank no longer expects a recession, which it did just six months ago, and is increasingly confident of a soft landing in the economy.
But its dot plot forecast of interest rates implies that the Fed may impose one more rate hike this year, which would lift that policy rate by 25 basis points to a range between 5.5% and 5.75%. At the same time, though, the Fed also implied that 50 basis points of rate cuts are on the way next year.
The dot plot forecast of interest rates implies that the Fed may impose one more rate hike this year.
To be sure, the Fed is better off keeping a rate hike later this year on the books rather than removing it and then having to push rates higher. Whatever the case, near term risks around the outlook linked to labor action in the auto sector, a possible government shutdown, the restarting of student loan payments and higher oil prices are all part of the risk matrix that the Fed must navigate as it makes policy decisions on rates in November and December.
Because of the lagged impact of past rate hikes, financial stress across privately held firms in the real economy is rising, and the Fed should proceed carefully and not impose any additional rate hikes in this cycle.
In our estimation, further rate hikes would be a policy error that results in a premature end to the current business cycle.
In addition, as inflation falls, real interest rates rise. So even an extended pause will result in a further tightening of financial conditions. It is important to note that long-term real rates using 10-year Treasury Inflation-Protected Securities as the benchmark stand just under 2% in contrast with the 0.26% average over the past decade.
A policy decision to let real interest rates rise as inflation comes down would result in an unnecessary recession.
For this reason, the central bank needs to shift in a gradual and orderly fashion toward focusing on stabilizing real rates and begin preparing investors and other policymakers for rate cuts by no later than the second quarter next year to ensure the sustainability of the economic expansion.
Policy statement
The Federal Open Market Committee’s policy statement has a key passage: “The Committee will continue to assess additional information and its implications for monetary policy. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will consider the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
Read more of RSM’s insights on the economy and the middle market.
This language reaffirms the Fed’s commitment to long-term price stability, keeps open its options to hike rates further and notes the lagged impact of past policy hikes. That lag offers the Fed a window to focus on real rates and, eventually, begin rate reductions over the next year, which is what the Fed’s forecast now implies.
Dot plot
The dot plot in the near term was a status quo affair. There was no hike at this meeting, and 12 members expect one more rate hike of 25 basis points this year, which was unchanged from the committee’s position at the June meeting.
But 11 Fed members now think that the policy rate will stand at 2.9% in 2026. This implies that a growing number of policymakers at the Fed believe that the natural rate of interest, which is critical to the formulation and setting of policy, has moved upward.
In addition, despite the reaffirmation of the central bank’s 2% inflation target, a move upward of the natural rate of interest suggests that the conversation around a higher inflation target will grow louder over the next year.
Summary of Economic Projections
From our point of view, the major development from the Fed’s policy meeting is that the central bank no longer sees a recession coming—a position it held six months ago—and now believes that a soft landing is the base case for the economy.
Given the inflation shock, the late start on hiking rates and loss of credibility by the Fed, a soft landing would be an extraordinary policy achievement.
The Fed’s estimation of gross domestic product this year increased to 2.1%, up from its forecast of 1% in June. The central bank now expects a 1.5% growth rate next year, up from its forecast of 1.1% in June, and 1.8% growth in 2025 and 2026.
The Fed’s estimate of the unemployment rate for this year now stands at 3.8%, down from 4.1% in June, and the Fed thinks that rate will hold next year and in 2025. The Fed’s estimate of full employment remained at 4%, so the central bank is communicating to investors, policymakers and firm managers that the American labor market will remain historically tight in the near future.
The federal funds rate projection implies a 5.6% rate this year. For next year, the Fed projects a 5.1% rate, which is up from the 4.6% rate it forecast in June. For 2025, the central bank now forecasts a 3.9% rate, compared to its forecast of 3.4% in June. Finally, in 2026, the Fed forecasts that the policy rate will drop to 2.9%.
Higher for longer is now the baseline policy on rates.
Understanding what this means in terms of tighter financial conditions, rising real rates and the cost of doing business is essential for small and midsize firms that will have to manage risks around payroll and financing expansion over the next year.
Finally, the inflation forecast, like the other variables in the estimate, is much more constructive and encouraging. The core personal consumption expenditures index for this year is now anticipated to peak at 3.7%, down from 3.9% previously, and is estimated to be 2.6% next year, 2.3% in 2025 and 2% in the long run.
The takeaway
The September FOMC policy decision was positive and implies that the Fed’s baseline scenario for the economy is a soft landing, which should provide relief to firms that have been planning for a recession.
While the Fed may hike rates in November or December, depending upon the risks to the economic outlook, we think that, given tighter financial conditions in the real economy, the Fed should refrain from further rate hikes and prepare the ground for cuts, which we think need to start as early as the second quarter of next year.
