With a half-point cut, the Fed sent a strong signal that it intends to support jobs and growth.
Key takeaways
More rate cuts are on the way, the Fed suggested in its forecast, to hit 3.4% by the end of next year.
As financing costs decline, households and firms will be able to invest and improve their economic prospects.
When the Federal Reserve cut its policy rate by a half percentage point in September, it sent a clear signal to the market: that it was willing to take bold action to shore up the labor market and preserve the soft landing in the economy.
The central bank also laid out a path of monetary policy that suggests it intends to further cut rates by an additional quarter percentage point at its November and December meetings.
The policy rate, which stands between 4.75% and 5%, should end this year at 4.4% and decline to 3.4% by the end of next year, according to the Fed’s Summary of Economic Projections released in September.
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 central bank has grown more confident about 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.
The primary rationale cited by Federal Reserve Chairman Jerome Powell for the 50-basis-point rate cut in September was a slower 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—a clear demonstration of intent and policy objective—and to 4.3% in 2026 and 4.2% by 2027 and in the long run.
The Summary of Economic Projections implies that the Fed now operationally defines the non-accelerating inflation rate of unemployment, or NAIRU, as 4.2%. NAIRU is the level of employment that neither encourages nor discourages inflation.
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, the Fed intends to pursue the employment policy objective through less restrictive rates on the way back to the Fed’s projected terminal funds rate of 2.9%.
This rate is in line with our estimate of a terminal rate in the post-pandemic economy of 3.25%.
But if inflation proves persistent, especially in the service sector, then the rate could see less than the 225 basis points of 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 while employment is slowing, improved productivity is the likely source of that growth.
We may see future upward revisions to the Fed’s growth projections, which could alter the rate path.
Policy directions
Our preferred model of the Federal Reserve’s policy changes 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 NAIRU.
Those figures suggest that the Fed needs to quickly move its policy rate down by 150 to 175 basis points in the near term as inflation eases.
Recent market pricing 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.
The takeaway
The Federal Reserve took the first step in its new regime of lower rates by cutting the policy rate by 50 basis points and presenting a forecast that points to a neutral rate of 2.9%.
The aggressive cut shows that the central bank is focusing on maintaining full employment and creating the conditions to support the soft landing of the economy achieved through the past three years of difficult policy decisions.
RSM contributors
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