The Stock Market Expects the Fed to Cut Interest Rates More Than It Can

With U.S. inflation easing, the Federal Reserve is expected to lower its benchmark interest rate by another quarter-point this Thursday. Stock investors are especially interested in how much further the Fed can bring rates down, hoping for a positive impact on the market similar to the response following September’s half-point rate cut, when major indexes surged.

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Although the Fed aims for a 2% inflation target, this goal is somewhat arbitrary. The central bank might settle for a slightly higher inflation rate if it still supports overall price stability. Price stability is achieved when inflation is low enough that it doesn’t significantly affect household or business decisions.

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In such an environment, consumers feel no rush to spend immediately to avoid future price hikes, and businesses aren’t hesitant to invest due to concerns that falling prices during periods of weaker demand could make loans difficult to repay.

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A key issue remains the "neutral" interest rate, or the rate at which the federal funds rate is low enough to promote maximum employment while fostering investment sufficient for potential economic growth. This rate is high enough to prevent excessive spending that could overheat the economy and drive up inflation but not so high that it stifles growth. Known as “r-star” among economists, the neutral rate represents this balance point.

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Federal Reserve policymakers project that inflation will eventually stabilize around 2.0%, with the federal funds rate likely to settle at 2.9%. This implies a neutral rate of around 0.9%. However, that limited margin might hinder the Fed’s ability to reduce rates sufficiently in response to future economic downturns. Historically, during past easing cycles from the 1960s through the pandemic, the Fed has typically reduced rates by about 5.3 percentage points to address crises.

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Over the decades, both the Fed’s views and econometric estimates of the neutral rate have been gradually decreasing, shaping expectations of where the federal funds rate should stabilize once inflation reaches its target. Various factors influence the neutral rate:

1. Economic Growth Potential: This factor relies on productivity gains and labor force growth. Higher growth potential would support greater entrepreneurial risk-taking, boost business investment, and lead to a higher neutral rate. However, if interest rates remain too low, businesses might overinvest, spurring inflation, while households may not save enough to support needed investments and manage government deficits.
2. Demographic Trends: In recent years, declining birth rates have slowed labor force growth, reducing both economic potential and the neutral rate. However, longer life expectancies and more years of potential productivity among older Americans increase the funds needed for retirement savings, also pushing down the neutral rate.
3. Risk Aversion: When American households favor safe assets like U.S. Treasurys and CDs, the pool of savings grows, even if returns are modest, and this influx can further lower the neutral rate.

In recent times, however, several factors appear to be raising the neutral rate. The Fed might be underestimating this rate, as well as the extent to which it can safely lower the federal funds rate without igniting inflation.

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The growing role of artificial intelligence, for instance, is driving a significant increase in capital demand. The extensive investments in processors, servers, data centers, software, and other infrastructure to support AI are expected to fuel productivity growth.

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Additionally, immigration policies under President Joe Biden have increased labor force growth, expanding the U.S. workforce beyond what might have occurred with indigenous population trends or the previous immigration policies under President Trump. This trend supports a higher neutral rate as it raises potential economic growth.

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After the Global Financial Crisis, many U.S. households were more risk-averse, focusing on deleveraging to rebuild their financial stability following heavy losses. As they emerged from the COVID-19 pandemic, American investors began to take on more risk again, particularly through stock investments and, among wealthier individuals, private credit funds.

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Currently, the federal deficit is around 7% of GDP—the highest peacetime level except during the Great Financial Crisis and the COVID-19 shutdowns, even surpassing figures from the Great Depression. This high deficit taxes the pool of available savings, which also elevates the neutral rate.

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Fed Chair Jerome Powell seems prepared to move beyond traditional neutral rate estimates, focusing instead on balancing the risks of tightening policy too much or too little based on real-time data. He may ultimately find that a federal funds rate higher than 2.9% is necessary to support the economy without over-stimulating it.

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Powell’s stance reflects an adaptive approach, indicating that the Fed’s actions will not be bound strictly by neutral rate estimates but will remain responsive to evolving economic indicators.

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