The Federal Reserve concludes its policy meeting tomorrow on 26th July. The consensus forecast is that the Fed will hike the fed funds rate by 25 basis points to a range of 5.25-5.50%. It has been raised in almost record time from 0% in March 2022. Will tomorrow’s rate hike be the last? A lot depends on where the equilibrium or neutral rate lies, defined as the real fed funds rate (after subtracting inflation) that neither stimulates not restricts the economy.

The level of the neutral fed funds rate is objective and open to fierce debate, especially now after such a rapid and substantial tightening in monetary policy. Economists are divided in two camps. One believes that the fed funds rate is already in restrictive territory and a recession is on the horizon due to the lagged impact of rate hikes so far. The other believes that rates are not yet restrictive, that a recession is not on the horizon and that the Fed will need to tighten more in order to beat inflation.

Independent global investment research firm, Alpine Macro, makes a compelling argument that the fed funds rate is already well above the neutral rate and macro trends are likely to keep the neutral rate low over the long-term. Alpine Macro cites the Federal Bank of New York’s equilibrium rate model, which captures the effect of the Covid shock. According to the model the neutral rate has dropped to 0.6% which is below the pre-pandemic level, suggesting the fed funds rate is already around 2% above the neutral rate. Alpine Macro cautions that the Fed has no need to tighten further as real interest rates are already restrictive and inflation is coming down sharply. Headline US CPI has fallen from a peak of 9.1% in June 2022 to 3% in June 2023. Core CPI, which excludes food and energy prices, has dropped from a peak of 6.6% to 4.8%, a more modest reduction but if shelter is excluded core CPI would be 2.8%, close to the Fed’s 2% inflation target. The shelter component of CPI lags the actual housing market which has already dropped.

If the fed funds rate is already restrictive and inflation keeps coming down, it is likely that the Fed will be cutting interest rates over the next two years. Independent economic research company, Capital Economics forecasts the fed funds rate will peak at 5.25-5.50% and drop to 3.25-3.50% by end 2024, dropping further to 2.50-2.75% by the end of 2025. The prospect of sharply declining interest rates will be welcomed by financial markets.

Alpine Macro argues that the neutral policy rate will remain compressed globally over coming decades across the world due to long-term demographic and productivity trends and rising global inequality, which are all reducing the trend economic growth rate and therefore dictate a lower neutral interest rate. As the world’s population ages, the workforce is shrinking which reduces the potential economic growth rate. Productivity growth has been steadily tracking lower, which also reduces the potential economic growth rate and therefore commands a lower neutral interest rate. As global inequality rises, a larger proportion of wealth flows to the rich who are inclined to save more, having a similarly depressing effect on economic potential. The IMF forecasts that equilibrium real interest rates are likely to stay close to pre-pandemic levels in advanced economies in the coming years.

There are caveats to this view. The steady productivity decline may reverse course with the advent of artificial intelligence. Many research organisations are predicting an annual AI productivity boost of 1% or more over coming years, which would lift economic growth potential and the equilibrium interest rate. Consumers in the US and across Europe spent the decade following the 2008/09 Global Financial Crisis (GFC) deleveraging their balance sheets, creating space for a new credit boom. A new credit boom would also lift economic growth potential and the equilibrium interest rate. The energy transition will come with higher energy costs which would depress economic growth potential, but the need for bigger government budgets would provide a counterbalance.

A compressed equilibrium interest rate bodes well for lower interest rates in 2024 and 2025 and for financial markets. The proviso is that we avoid a painful recession. The pessimists warn that rising interest rates take anywhere between 12-24 months to work through the economy and since the Fed started raising interest rates 16 months ago, much of the impact is yet to be felt. However, others cite the greatly improved household, company and bank balance sheets due to the decade of post GFC deleveraging and accumulated excess savings from Covid-era handouts, which make the private sector impervious to increased interest rates.

The latest Wall Street Journal economists’ survey conducted from 7-12th July suggests the US economy will avoid a hard economic landing. The average forecast is for US GDP to have grown at a 1.5% annual rate in the second quarter (Q2) up from the 0.2% forecast in the previous survey. For Q3 they expect 0.6% growth compared to the 0.3% contraction projected in the previous survey. They only expect a mild 0.1% contraction in Q4 and for 2024 they forecast 1% growth, double the previous forecast of 0.5%. It seems a US recession, if it occurs at all will be mild and short-lived, the proverbial soft landing, which combined with disinflation and falling interest rates would be extremely positive for equity markets.