The Federal Open Market Committee’s meeting on Sept. 18 will implement a significant turn away from a focus on price stability—which has been achieved—to supporting maximum sustainable employment.
In turn, the policy pivot will create the conditions for greater fixed business investment, increased household spending, a bigger appetite for leverage and higher asset valuations over the next year.
We expect the Federal Reserve will start next week by reducing its policy rate by 25 basis points to a range between 5% to 5.25%.
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Over the next year, we expect the Fed to cut its policy rate to at or near 3.25%, which we think is vicinity of the neutral rate in the post-pandemic economy. That rate would imply a real neutral rate, after adjusting for inflation, of around 1% to 1.5%.
Recent economic data has been solid enough, with service and housing inflation still sufficiently sticky, that there is not a majority on the committee to support a 50-basis point cut next week.
While one should not rule out 50 basis-point cuts in the coming months should labor market conditions deteriorate, for now we are projecting a series of 25 basis-point cuts this year as our baseline forecast.
What we would like to see
The Federal Reserve is overly data dependent and relies too much on economic reports that are backward looking. Now, as the Fed pivots, it is time for the central bank to emphasize a forward look not only to map out the destination of the federal funds rate but also to sketch out how it will get there.
To do that, Federal Reserve Chairman Jerome Powell needs to address what he thinks the new post-pandemic neutral rate of interest will be, as well as provide ideas around the natural rate of unemployment, or the non-accelerating inflation rate of unemployment (NAIRU). That’s the lowest level of unemployment without triggering inflation.
Market participants and other policymakers depend on clear messaging from the Fed in these forecasts.
What we expect
The Fed’s dot plot, which serves as its members’ policy rate forecast, will feature major changes to median dots for this year and next.
We expect the median dot to decline from 5.125% to 4.375% this year (implying two 25 basis-point cuts this year in addition to next week’s cut). We also expect the median dot for next year to ease to 3.125%.
If the Fed retains its current long-run projection of a 2.8% federal funds rate, then it should be anticipated that the 2026 median dot will decline by another 25 basis points to 2.875%.
We anticipate that the dot plot will include a large dispersion of forecasts, which will presage the first dissent in 17 meetings. We would not be surprised if the president of the Chicago Federal Reserve, Austan Goolsbee, dissents in favor of a 50-basis point reduction.
Summary of Economic Projections
We expect that the next Summary of Economic Projections will feature an increase in the unemployment rate projection to 4.4% for this year while the estimate of 4.2% for next year and 4.1% for 2026 will remain unchanged.
The projection for the personal consumption expenditures index, which is the Fed’s preferred measure of inflation, will decline to 2.3% for this year from the current 2.6%. The forecast for next year will decline to 2% and stay at that level for 2026, which would be unchanged from previous projections.
We expect no change in the forecast of gross domestic product, which stands at 2.1% for this year and 2% for next year and for 2026.
The takeaway
The Fed’s policy decision next week will put forward major changes to its outlook, including the dot plot, the Summary of Economic Projections and the language within the statement around economic conditions.
The Fed will show confidence that inflation is returning to its 2% target, and it will put a greater focus on preserving maximum sustainable employment—the other half of its dual mandate in addition to price stability.
The tilt in the balance of risk toward protecting jobs will result in a shifting of expectations on the rate path over the next year. This pivot will bolster risk taking and encourage business investment as cash flows are unlocked.
