Key Takeaways
- Financial markets are betting the Federal Reserve will cut its benchmark interest rate rapidly over the next year and a half, putting downward pressure on mortgages and other kinds of loans.
- Typically, the Fed only cuts rates as much as markets currently expect during recessions, when the central bank is trying to boost the economy.
- Financial markets have a poor record of predicting what the Fed will do in the long run.
Financial markets are betting that, in the year ahead, the Federal Reserve is going to cut interest rates as drastically as it typically does during recessions. However, market predictions on rates have a poor track record of actually panning out.
The Fed will likely cut its benchmark fed funds rate 1.75 percentage points from its current level between now and September 2025, according to the CME Group’s FedWatch tool, which forecasts rate movements based on fed funds futures trading data. In the past, the Fed has only cut interest rates that fast when it wants to counteract a serious economic downturn. The last time it cut its rate that much that quickly was during the Great Recession.
The Fed has held the rate at a 23-year high since last July, pushing up borrowing costs on mortgages and other loans, in an effort to slow the economy and stifle inflation. With inflation falling toward the Fed’s annual goal of a 2%, and the job market showing recent signs of weakness, economists expect the Fed’s focus is set to shift away from fighting inflation, and toward boosting the economy.
Markets widely expect the Fed will begin to cut rates from its current level in September. The big question for policymakers, and markets, is how fast the Fed will cut after that. The last time they were polled in June, Fed officials themselves projected that by the end of 2025, they’d cut the rate down to a range of 4%-4.25% from its current level of 5.25%-5.5%. That would only be 1.25 percentage points of rate cuts over 18 months, much less than what markets predict.
‘Almost Always Wrong’
Markets have a poor track record of predicting the Fed’s actions over the long term. Traders have often bet on drastic rate cuts in the past, only to see those hopes dashed and the Fed take a more cautious approach.
For instance, at the outset of 2024, markets expected steep rate cuts. Those bets didn’t pay off though, because the Fed instead held rates steady after inflation proved unexpectedly stubborn in the first quarter.
“The market has an inbuilt dovish rates bias,” Jim Reid, a research strategist at Deutsche Bank said in a research note.
Torsten Slok, chief economist at Apollo, put it bluntly in an analysis last October.
“The market is almost always wrong about what the Fed will do,” he wrote.