Projected US Interest Rates in 5 Years: Is the Fed Done With Hikes?
On Wednesday, December 13, the U.S. Federal Reserve adhered to expectations by maintaining its benchmark interest rate, signaling a potential shift towards rate cuts of up to 75 basis points over the next year.
This decision, an extension of the monetary policy pause initiated in July, maintains the federal funds rate at a notable 5.25% to 5.5%, marking a 22-year high.
However, the accompanying economic projections led to a forecast from Federal Reserve officials, suggesting a potential reduction of rates by approximately 75 basis points in the upcoming year. The most recent quarterly dot plot illustrated this, with officials anticipating rates between 4.4% to 4.9% by the close of 2024. A slim majority within the Federal Open Market Committee foresees at least three quarter-point cuts from existing levels.
This decision aligns with the US central bank’s overarching objective: balancing the need for sufficiently tight monetary policy to curb inflation back to its 2% target while safeguarding the economy and minimizing job losses—an endeavor often referred to as achieving a ‘soft landing.’
At Least Three Cuts In 2024
The Federal Reserve announced its commitment to evaluating potential adjustments in monetary policy aimed at restoring inflation to the target rate of 2%. The central bank said it would consider the cumulative effects of tightening monetary policy, recognizing time delays involved in the impact of such policies on economic activity and inflation, and remaining attentive to ongoing economic and financial developments.
In a statement , the Committee confirmed its ongoing commitment to analyzing additional information and its potential implications for monetary policy.
The Federal Reserve acknowledged moderate job gains compared to earlier in the year but emphasized their continued strength, coupled with a persistently low unemployment rate. Despite a recent easing of inflation over the past year, it remains high.
The Fed also acknowledged that heightened financial and credit constraints for households and businesses could put pressure on economic activity, hiring, and inflation.
Dot Plot Expectations
Fed chairman Jerome Powell addressed the question of when it would be appropriate to initiate a reduction in the current policy restraint during the meeting. He acknowledged this had ramifications outside the central bank.
Ian Shepherdson from Pantheon Macroeconomics pointed out that the Fed was catching up with the reality that market confidence has been dwindling for quite some time.
Paul Ashworth at Capital Economics said the first rate cut was likely to occur in March next year. Further 25-basis-point reductions will occur at each subsequent meeting, accumulating to a total decline of 175 basis points over the year. Ashworth said he thought the nominal fed funds rate could reach as low as 3% in the first half of 2025.
Contrary to the dot plot projections, Shepherdson suggested a more accelerated rate of cuts. The analyst forecasted a 150-basis-point reduction next year, starting in either March or May, and an additional 100-basis-point cut in 2025. Shepherdson emphasized the importance of policymakers responding to the data. He expressed the belief that inflation woukd recede at a quicker pace than the central bank anticipates.
Interest Rates’ Impact on Financial Markets
Projections and decisions regarding interest rates hold immense sway over the broader economy, affecting various financial markets, including equities, bonds, and commodities.
The Fed’s key tool in this regard is the Federal Funds Rate (FFR). This serves as the base interest rate that influences banks, bond markets, and the overall economy. The Fed makes these rate decisions during its Federal Open Market Committee (FOMC) meetings, held eight times a year. The rate adjustments in 2022 brought about several hikes, with more in store for 2023.
The increase in FFR, in turn, leads to a rise in the prime rate, the fundamental interest rate charged by banks to creditworthy customers. If the FFR goes up, so do the cost of loans and mortgages. This uptick in the cost of servicing loans translates to reduced discretionary income for consumers and businesses. This, in turn, can dampen overall demand and mitigate inflationary pressures.
The implications for stocks are twofold: consumer-dependent sectors like retail and hospitality may face headwinds due to reduced consumer spending. Growth stocks that rely on capital and borrowing could also suffer, as investors shift their focus toward more stable, value-oriented investments in response to market volatility and potential downturns.
Pressure On Bonds
From a mechanical perspective, rising interest rates put downward pressure on bond values. As rates climb, the yield on bonds becomes less attractive compared to the prevailing base rate. This has led to a sell-off in bonds.
This effect is particularly pronounced in the case of long-term bonds, as the discrepancy between their yield and the base rate grows over time.
As a result, fixed-income securities also lose value as the opportunity cost of not owning interest-rate tracking assets increases. Thus, predicting interest rates over the next five years becomes a critical indicator for market trends.
High Rates Critical To Lower Inflation
The recent Federal Reserve Beige Book signals a slowdown in U.S. economic activity. It offers a less optimistic outlook for the next six to twelve months. The survey covers 12 Federal Reserve districts, depicting modest growth in four, flat to slightly down conditions in two, and slight declines in six.
Retail sales, including autos, displayed mixed trends, while sales of discretionary items and durable goods experienced declines, reflecting heightened consumer price sensitivity. Travel and tourism remained robust, yet demand for transportation services lagged. Manufacturing activity showed a varied performance, with some manufacturers expressing weakened outlooks.
The report notes a slight decrease in demand for business loans, particularly in real estate, while consumer credit remains relatively healthy despite a minor uptick in delinquencies. Commercial real estate activity continues to slow, particularly in the office segment.
Labor market dynamics reveal easing demand for labor, with flat to modest increases in overall employment reported across most districts. Reductions in headcounts through layoffs or attrition were observed, despite some districts describing tight labor markets with shortages in skilled workers.
Wage growth remained modest to moderate, reflecting a general easing in wage pressures, and some districts reported declines in starting wages. Price increases, while moderated, remain elevated. Most districts anticipate moderate price increases to persist into the next year.
Pressure On Economic Activity
Officials noted that the current restrictive monetary policy was dampening economic activity and inflation. Furthermore, it’s led to tightened financial conditions in recent months. The minutes revealed a consensus that a period of below-potential growth in real GDP, coupled with some softening in labor market conditions, was deemed necessary to address inflation pressures adequately.
Despite this, officials noted that aggregate demand and aggregate supply were gradually balancing due to the current restrictive monetary policy and the ongoing normalization of aggregate supply conditions.
Subsequent to the meeting, a notable deceleration in inflation and signs of labor market softening emerged, fostering investor belief that interest rates may have reached their peak.
Historical Perspective on Interest Rate Policy
The US has experienced periods of both high and low-interest rate volatility in its history. In the postwar era of the 1950s, the FFR remained below 2%, bolstered by postwar stimulus and income growth. Over the next two decades, the rate fluctuated between 3% and 10% during the 1960s and 1970s, soaring to a record high of 19.1% in 1980 amid rampant inflation.
As the US economy stabilized and inflation was brought under control, the FFR hovered around 5% throughout the 1990s. However, recessions in 2001 and 2008 forced rates down to historically low levels, where they remained until 2016.
The COVID-19 pandemic necessitated another significant rate cut, nearly to zero. In 2022, the Fed increased rates seven times, followed by three hikes in 2023. The central bank brought the rate to its current range between 5.25% and 5.50%, the highest level in 16 years.
Factors Influencing Future Interest Rates
The Fed now faces the challenge of navigating uncertain economic conditions, marked by rising prices and an economic slowdown compounded by supply chain disruptions. Inflation, as well as the potential for a recession, are top concerns.
High Inflation
Inflation has been a focal point for central bank action. In 2022 and 2023, inflation was driven by a mix of demand and supply factors, sometimes interconnected. The Fed’s more hawkish stance appeared to have contributed to a moderation in price increases. In the May meeting, Fed Chair Jerome Powell indicated that the central bank no longer anticipates additional rate hikes but remains data-dependent.
The rhetoric shifted in July when official data from the US Labor Department revealed that the inflation rate had reached 3.2% year-over-year, driven by increased costs in housing, car insurance, and food.
This marked an uptick from June, which had seen the lowest rate in over two years, at 3.0%. Analysts had anticipated this rise in the headline rate, considering the relatively weak price inflation observed in the previous July.
US Dollar Resilience
Despite economic turbulence, the U.S. dollar has remained remarkably resilient. Its status as a safe-haven currency, coupled with increased investor appeal due to the Fed’s hawkish monetary policy, has bolstered its performance. However, as the Fed’s monetary tightening slows and potentially pauses, the strength of the US dollar appears to be waning.
Is Recession Looming?
Balancing the need to curb inflation without stalling economic growth is a complex endeavor. And the Fed seems to be managing it relatively well. While the U.S. is not currently in a technical recession, economic growth has been decelerating over the recent quarters.
The U.S. economy grew at a slightly less brisk pace than initially thought in Q2 as businesses liquidated inventory. But momentum appears to have picked up early this quarter as a tight labor market underpins consumer spending.
Gross domestic product increased at a 2.1% annualized rate last quarter, the government said in its second estimate of GDP for the April-June period. That was revised down from the 2.4% pace reported last month. Economists had expected GDP for the second quarter would be unrevised.
Projected Interest Rates in the Next Five Years
Analysts primarily focus on near-term interest rate forecasts, but long-term projections extend over the next several years. These forecasts offer valuable insights into interest rate expectations.
An interest rate forecast by Trading Economics indicates that the Fed Funds Rate could reach 5.50% by the end of the current quarter. The forecast anticipates a gradual decline to 3.75% in 2024 and further to 3.25% in 2025, according to econometric models.
Similarly, ING’s interest rate predictions indicate rates at 5.50% in the second and third quarters of 2023. In 2024, they foresee rates starting at 4%, with subsequent cuts to 3.75% in Q2 2024, 3.5% in Q3 2024, and 3.25% in the final quarter of 2024. In 2025, ING predicts a further decline to 3%.
The University of Michigan inflation expectations in the U.S. for the five-year outlook were revised slightly higher to 3% in August 2023. This is higher than the preliminary estimate of 2.9%, matching July’s reading.
Rate Cuts On The Horizon?
Economic growth was seen in a range between 1.2% and 1.7% in 2024, and 1.5% and 2.0% in 2025. Core PCE inflation is expected to fall to between 2.4% to 2.7% in 2024 and 2.0 to 2.2% in 2025.
Meanwhile, experts surveyed by Trading Economics note a decline in U.S. consumer inflation expectations for the coming year.
Expectations for year-ahead price growth have shifted, with gas decreasing by 0.2% to 4.5%, and food by 0.1% to 5.2%, the lowest since September 2020. Medical care will decrease by 0.9% to 8.4%, the lowest since November 2020, and college education by 0.3% to 8.0%. Rent will fall by 0.4% to 9%, the lowest since January 2021.
Also, median home price growth expectations decreased to 2.8% in July from 2.9% in June. Meanwhile, consumers also see lower inflation in three years at 2.9% from a previously expected 3.0% and in five years at 2.9% from 3.0%.
Economic Activity Improves
Figures from the Bureau of Economic Analysis revealed the U.S. economy experienced even stronger growth than initially projected in the Q3. The quarter-on-quarter gross domestic product (GDP) expanded by an annualized rate of 5.2% in the three months to September 30. It surpassed the 2.1% growth observed in the second quarter.
An earlier estimate reported a month ago had suggested a 4.9% growth for the same period. The Bureau of Economic Analysis credited the upward revision to nonresidential fixed investment and state/local government spending. To partially balance this was a consumer spending downturn. Crucially, the boost in real GDP was fueled by increased consumer spending, private inventory investment, exports, government spending at various levels, and both residential and non-residential fixed investments.
This represents the most significant quarter-on-quarter GDP growth since Q4 2021’s 7.0% increase, reflecting five consecutive quarters of economic expansion. On a year-on-year basis, US GDP accelerated to 3.0% in Q3 from a 2.4% increase in Q2. The latest reading, revised upward from the initially reported 2.9%, marks the fastest annual GDP growth since Q1 2022’s 3.6% rise.
Despite the Federal Reserve’s decision to raise rates by 525 basis points since March 2022, the data indicates that the US economy has built significant momentum in the last quarter.
Factory, Labor And Wages Trends
Manufacturing activity displayed mixed results, though multiple districts showed a brighter outlook for the sector.
The labor market showed signs of easing nationwide, with most districts reporting slight to moderate increases in overall employment, albeit with a reduced sense of urgency among firms in their hiring efforts. However, recruiting and hiring skilled workers remained challenging.
Wage growth remained moderate, with candidates showing less resistance to wage offers. Many firms adjusted their compensation packages to offset higher labor costs, incorporating measures like remote work options instead of wage increases, reduced sign-on bonuses, or other enhancements.
Price trends indicated modest overall increases, with input costs stabilizing or slowing for manufacturers while continuing to rise for service sector businesses.
Factors such as fuel costs, wages, and insurance contributed to price growth. Sales prices increased at a slower rate than input prices, as businesses grappled with passing on cost pressures due to heightened price sensitivity among consumers, thus impacting profit margins.
In the coming quarters, firms generally anticipate price increases, but at a slower pace compared to previous periods. Several districts reported a reduced number of firms expecting significant price hikes in the foreseeable future.
How Do Interest Rates Affect Crypto?
Bitcoin and other digital assets have demonstrated resilience in a rising interest rate environment. For instance, Bitcoin experienced remarkable growth of 2,000% in 2015 and 2016, during a period marked by rising interest rates.
Nevertheless, some experts argue that persistently high inflation, gas prices, and energy costs resulting from elevated interest rates may dampen risk appetite, potentially posing headwinds for cryptocurrencies.
Central Banks and Connection With Cryptocurrencies
Central banks wield significant influence, directly affecting money circulation and financial market stability. They have the power to modify interest rates, which, in turn, affects the borrowing rates for financial and banking institutions. Recently, central banks in major developed economies, such as the Fed, ECB, and BoE, have opted to increase interest rates in response to widespread inflation.
The increasingly intertwined relationship between cryptocurrencies and these macroeconomic and monetary shifts is noteworthy. In particular, the decisions to raise interest rates, especially by the Fed, have direct repercussions on the cryptocurrency markets.
In simpler terms, the Fed’s more assertive stance has cast a shadow over cryptocurrencies. This has an impact on market sentiment as tighter monetary policies loom.