Ahead of this week’s policy decision by the Federal Open Market Committee and the publication of the November personal consumption expenditures price index, a look at the Federal Reserve’s terminal rate is in order.
In the Federal Reserve’s Summary of Economic Projections released in September, that rate was set at 2.9%.
It is critical that firm managers, investors and policymakers understand the risks around a shallower path of interest rate reductions and its impact on cost of funding to support business expansion.
Read more of RSM’s insights on the economy and the middle market.
Our estimate using a forward-looking Taylor Rule implies a 3.71% terminal rate when setting the neutral real rate, or r-star, at 1.26.
We arrive at that rate using the Laubach-Williams one-sided estimate of the natural rate of interest and setting the non-accelerating inflation rate of unemployment, or NAIRU, at 4.2%.
This strongly suggests that the Fed will need to lift its estimate of the terminal rate at its policy meeting this week and throughout the coming year.
A forward look using this analytical framework matches up well with the federal funds futures market, which is pricing in a policy rate of 3.83% next December.
This rate implies a risk of only 50 basis points of rate cuts next year should the economy continue to outperform or inflation remain stubborn and sticky.
We expect that the Federal Reserve will lift its estimate of the terminal rate to 3% on Wednesday.
