Will Federal Interest Rates Continue to Drop

Wondering what's in store for interest rates?

Though the Federal Reserve has announced it's hiking interest rates—again—and economic turbulence persists, our long-term optimism about gross domestic product and inflation remains largely unchanged.

We think the Fed is slowing the economy enough to help rein in inflation without provoking a major slowdown, and we're projecting annual real GDP growth rates to remain in positive territory. Although real GDP dropped in the first half of 2022, we don't think this marks a true recession, and we expect growth to bounce back later in 2022.

When Will Interest Rates Go Down?

We expect the Fed will pivot to easing monetary policy in 2023 as inflation falls back to its 2% target and the need to shore up economic growth becomes a top concern. The full analysis is detailed in our 2022 U.S. interest-rate & inflation forecast.

1. Interest-rate forecast. We project a year-end 2023 federal-funds rate of 1.75%, compared with 3.25% for the consensus. Further out, our 2026 and long-run projection for the fed-funds rate and 10-year Treasury yield are 1.75% and 2.75%, respectively. We do, however, expect rates to dip below these levels in 2024 and 2025 as monetary policy leans accommodative.
2. Inflation forecast. We project price pressures to swing from inflationary to deflationary by 2023, owing greatly to the unwinding of price spikes caused by supply constraints in durables, energy, and other areas. This will make the Fed's job of curtailing inflation much easier. In fact, we think the Fed will overshoot its goal with inflation averaging 1.4% over 2023-26.

The inflation analysis is critical to our near-term projections for GDP and interest rates. If inflation becomes much more entrenched, the Fed will have to engineer a sharp short-run recession by hiking interest rates much higher than we expect.

As long as the Fed is allowed to shift to easing in 2023, GDP should continue trending upward and then accelerate in 2024 and 2025. Housing, which is the most interest-rate-sensitive major component of the GDP, will drive much of the fluctuation in GDP growth. Lower rates in 2024 and 2025 will be needed to improve housing affordability and thereby resuscitate demand in the housing market.

We Expect a More Delayed Recovery, but a More Bullish Long-Run GDP

Since our last update, we've slightly lowered our near-term GDP forecasts. Altogether since the start of the year, our near-term GDP forecasts have come down substantially owing to supply shocks (especially the war in Ukraine) and a heightened determination from the Fed to fight inflation with tighter monetary policy.

As shown below, we expect GDP growth will bounce back starting in 2024 as the Fed pivots to easing. Resolution of supply constraints should facilitate an acceleration in growth without inflation becoming a concern again. Increases to our GDP growth forecasts for 2025-26 partially make up for our downward revisions for 2022-23.

Though these GDP forecasts for 2022 and 2023 are slightly more bearish than current consensus, we're far more bullish in the longer run.

Based on available long-run forecasts, we're expecting about 2.5% more cumulative GDP growth than consensus through 2026. Consensus remains overly pessimistic on recovery in the labor supply and has generally overreacted to near-term headwinds.

Our five-year GDP forecasts are driven by our detailed analysis of the labor market and the other supply-side building blocks of the economy.

Inflation Forecast 2022: Staying Hotter for Longer Than Expected

Our inflation forecasts for 2022 have edged higher, as supply disruptions now look to be taking somewhat longer to resolve than previously expected.

We're still expecting inflation to come down dramatically in 2023 and later years as supply constraints are resolved. The downward revisions to our GDP forecast, shown on the chart below, also mean a more negative output gap in the near term than we expected, which will cool off inflation further.

On inflation, our views diverge sharply from consensus after 2022. Bond market breakevens imply a similar view as consensus on inflation.

While consensus has greatly given up on the "transitory" story for inflation, we still think most of the sources of today's high inflation will abate (and even unwind in impact) over the next few years. This includes energy, autos, and other durables.

Combining these factors with monetary policy tightening, we expect inflation to undershoot 2% in 2023 and 2024. Worries about inflation broadening out into the rest of the economy (including via high wage growth) look overblown.

U.S. Interest-Rate Forecast: What We See for the Future

Our interest-rate forecast isn't just driven by the Fed, but by broader long-term forces that act to push down interest rates in the U.S. and other major economies for decades.

In other words, the natural rate of interest has shifted downward because of demographics and slower productivity growth, among other factors. For this reason, our interest-rate forecast includes the expectation that these rates will stay lower for longer.

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Source: https://www.morningstar.com/articles/1106505/why-we-expect-the-fed-to-cut-interest-rates-in-2023#:~:text=Interest%2Drate%20forecast.&text=Further%20out%2C%20our%202026%20and,as%20monetary%20policy%20leans%20accommodative.

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