Scott Colbert
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Key Highlights
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After much anticipation from market watchers, the Federal Reserve (Fed) lowered its target range for the federal funds rate by a half percentage point, or 50 basis points, in September. The federal funds rate, the interest rate commercial banks charge each other for lending and borrowing their reserve balances overnight, now stands at a target range of 4.75% to 5.0%. With the Fed forecasting an additional 50 basis points in rate cuts for 2024 and another 100 basis points in 2025, Commerce Trust believes the U.S. central bank is recalibrating its monetary policy from restrictive toward normal, or neutral.
Recall that the Fed began an aggressive rate-hiking strategy in March 2022 to combat rising inflation, which peaked at 9.1% as measured by the Bureau of Labor Statistics’ Consumer Price Index (CPI) on a year-over-year basis in June of that year. As of September 2024, the CPI has fallen to 2.4%. In addition, the Bureau of Economic Analysis’ Personal Consumption Expenditures Price Index (PCE), the Fed’s preferred inflation gauge, followed a similar pattern. After peaking at 7.2% in June 2022, the PCE stands at 2.2% as of this past August.
Figure 1 - Inflation Year-Over-Year Will Continue to Fall as the Year Progresses
The Fed has a dual mandate of price stability, as measured by its 2% inflation target, and maximum employment. It appears the Fed is confident enough with the continuing downward trend in inflation that it can focus on the U.S. labor market, which has experienced weakening since the start of the year. With a shift towards a less restrictive monetary policy, the Fed is attempting to find a neutral federal funds rate that neither accelerates nor restricts economic growth as it seeks to balance both inflation and employment.
What is a neutral federal funds rate?
The challenge now for the Fed is finding a range of normal interest rates. Using history as a guide, we provide a framework to identify the real federal funds rate, or an interest rate adjusted for inflation. To do this, we look at the federal funds rate relative to inflation, as measured by trailing CPI, which shows an average difference between the two measures of 91 basis points, or just under 1%, since 1970.
Figure 2 - Fed Funds Rate Minus Inflation (Fed currently is modestly restrictive)
With the high end of the federal funds rate currently at 5.0%, subtracting the September CPI reading of 2.4% gives us a real federal funds rate of 2.6%. When adjusted for inflation, this suggests the real federal funds rate is currently 170 basis points higher than average. If we then factor the Fed’s forecast for 150 basis points in rate cuts by the end of 2025, this indicates the Fed could be approaching a neutral federal funds rate by the end of next year.
To further complicate matters, the Fed’s 2% inflation target is based on the PCE, not the CPI, which has averaged approximately 60 basis points higher than the PCE since the 1970s.
Figure 3 - Historic Inflation Averages: 1970 – present
So, one might expect to find a 2% PCE inflationary environment roughly corresponding to a 2.6% CPI. Provided inflation continues trending toward the Fed’s target and factoring an average federal funds rate being approximately 90 basis points higher than the CPI, Commerce Trust estimates a federal funds rate range of 3.0% to 3.8% could be a potential landing area for a neutral federal funds rate.
The impact on the yield curve
The historical average Treasury yield curve has been upward sloping, with short-term rates lower than long-term rates. However, an inverted yield curve, when yields on 2-Year Treasury bonds are higher than yields on 10-Year bonds, has been in place since July 2022. Although it has been flattening, a yield curve inversion has historically been a reliable recession indicator, preceding 10 of the past 10 U.S. recessions.
Assuming inflation returns to a 2% target, short-term rates are likely to decrease, and the curve is expected to resume its upward slope. Commerce Trust estimates what a more normalized yield curve could look like.
Figure 4 - Treasury Yield Curves (as of October 11, 2024) Current and potential normalized estimates
While we believe short-term rates may still have room for additional reductions, the longer end of the yield curve tells a different story. It appears likely that future interest rate cuts have already been discounted on longer duration Treasury bonds. Historically, these yields typically don’t move materially unless we enter a significant economic slowdown, in which case, the Fed would likely continue to lower rates, moving beyond a neutral rate to a position of accommodation.
With the Fed’s efforts to normalize interest rates now underway, it’s important to recognize that capital markets often take time to adjust to rate-cutting cycles once they begin. The wealth management team at Commerce Trust can help you assess your portfolio and ensure it aligns with your long-term financial goals in what continues to be a dynamic economic and market environment.
The Chartered Financial Analyst® (CFA®) Charter is a designation granted by CFA Institute to individuals who have satisfied certain requirements, including completion of the CFA Program, and required years of acceptable work experience. Registered marks are the property of CFA Institute.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of October 28, 2024. This summary is not intended to provide general information only and is reflective of the opinions of Commerce Trust. This material is not a recommendation of any particular security, is not based on any particular financial situation or need and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional.
Diversification does not guarantee a profit or protect against all risk. Commerce Trust does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
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