We have the out-of-consensus view that the fed funds rate will return to zero. We stress test this view by considering how policy might behave under different growth, inflation, and r* forecasts. If, as we expect, a recession occurs, a return to zero is the most likely outcome. But risks are skewed to a shallower cutting cycle.
  • Banking sector turmoil means interest rate cuts are being taken more seriously by the market than they were a week and a half ago.
  • We first made a US recession and a sharp rate-cutting cycle our baseline in June 2022. Even after recent repricing, we have the out-of-consensus view that the fed funds rate will return to zero by 2025.
  • We expect a US recession starting in Q3 this year, which takes 2% off US GDP, pushes unemployment up to 6%, and takes core PCE inflation to 1%.
  • The average of a variety of policy rules conditional on these economic forecasts sees the appropriate fed funds policy rate falling to zero. History also suggests a cutting cycle of this magnitude is consistent with how policy makers respond to recessions.
  • We stress test our base case policy rate forecast under different growth, inflation, and r* outcomes. Were the Fed able to engineer a soft landing, or inflation to prove much stickier amid a recession, a return to zero would no longer be appropriate. But it’s uncertainty over the possibility of a much higher short-term r* which is the key risk to our cutting cycle forecast.
  • Therefore, the weighted average fed funds rate across our baseline and alternative scenarios ends above zero but below the neutral rate. Nevertheless, this is still a deeper cutting cycle than is currently priced into markets.

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