In the following analysis, PIMCO’s Tiffany Wilding, Managing Director and Economist, and Allison Boxer, Economist, tell us why they believe the Fed is on a path to continue to cut rates over the next several meetings to realign monetary policy with a now more “normal” U.S. economy.
Following its September meeting, the U.S. Federal Reserve announced its first interest rate cut since 2020 – and did it with a bang. The central bank lowered the policy rate by 50 basis points (bps) and slashed its forward rate projections. The new median projection sees the policy rate ending 2025 in the range of 3.25%–3.5%, which is 150 bps lower than the current range and much closer to long-run neutral monetary policy estimates.
The Fed’s actions suggest that it saw a shift in the balance of risks around inflation and employment, warranting a faster adjustment toward neutral than many officials had previously thought. Historically, looking at Fed cycles since the mid-20th century, an initial rate cut of 50 bps has typically preceded or signaled a recessionary easing cycle – that is, a generally sharper, deeper, or more prolonged series of rate cuts aimed at bolstering a struggling economy.
We do not believe the U.S. economy is currently in recession; consumer spending remains resilient, and investment growth appears to be accelerating. However, as inflationary pressures subside, the Fed appears focused on ensuring U.S. growth and labor markets remain strong by aligning monetary policy with today’s economy – which looks much more “normal” now that the series of pandemic-related shocks that drove high inflation have largely subsided.
We believe the Fed is on a path to ease policy by 25-bp increments at each of its upcoming meetings. However, the Fed remains data-dependent. If the labor market deteriorates more quickly than expected, we expect the Fed to cut more aggressively.
A lot can change in three months
Fed officials made significant revisions to its economic and interest rate projections relative to June. Employment and inflation data since then have surprised many investors and sparked some market volatility. The balance of risks to the Fed’s dual mandate has shifted somewhat away from inflation – still slightly above target but moving sustainably in a good direction – and toward employment, which remains relatively strong but shows signs of weakening.
The Fed’s updated median economic projections for year-end 2024 reflect this recent data: Officials raised their unemployment rate projection to 4.4% (up from 4.0%) and lowered their core inflation projection to 2.6% (down from 2.8%). These changes informed the 75-bp downward revision to the median interest rate projections for both 2024 and 2025. The Fed likely aims to normalize policy more quickly to bolster employment and support economic growth more broadly.
U.S. economy and policy returning to ‘normal’ conditions
As the economy is likely normalizing, so too should monetary policy. While the transition back to normal need not be disorderly, it could make the economy more vulnerable to unforeseen shocks, especially if monetary policy remains overly restrictive.
With inflationary pressures subsiding, and real GDP growth and hiring slowing, the Fed appears more closely focused on ensuring the economy remains strong. We believe this view is consistent with the faster path toward neutral policy rates implied by Fed officials’ new interest rate projections. This rate trajectory likely depends on continued U.S. economic resilience; indeed, median Fed forecasts indicate consistently solid 2% growth, with the unemployment rate stabilizing just 20 bps above current levels. The rates market has now priced in a cutting cycle typical of a soft landing (or nonrecessionary) cutting cycle, but the market could still anticipate steeper cuts if recession risks increase materially. Overall, we think the Fed likely has room to cut rates further under a range of economic scenarios.
Range of views
The September Fed meeting also highlighted the range of views among officials. Governor Michelle Bowman dissented in favor of a 25-bp cut, marking the first dissent by a board member since 2005. The “dot plot” projections for 2024 suggest that the decision between a 25- and 50-bp cut was close, with nine officials preferring either no cuts or just one more cut by year-end. The other nine officials appear to support a sequence of 25-bp cuts following September’s initial 50-bp reduction.
The wide range in interest rate forecasts for 2025 – spanning 125 bps among the various officials – highlights the elevated uncertainty surrounding the future of the economy and policy. Inflation in August (as measured by the Consumer Price Index) was firmer than expected, a reminder that while risks have diminished, inflation has not yet returned to the Fed’s target. However, the recent loss of momentum in the labor market poses a risk of undershooting, which explains the Fed’s decisively dovish initial rate cut.
Implications for investors
Historically, intermediate-maturity bonds have tended to outperform cash during Fed interest rate cutting cycles. With the Fed starting with a bang, investors may benefit from locking in still-attractive intermediate yields. Bonds also offer hedging properties in the event that a harder landing prompts the Fed to cut rates more quickly. Learn more about investing during rate-cutting cycles in our recent PIMCO Perspectives, “Cuts and Consequences.”
