Goldman Sachs has forecasted that the Federal Reserve's current rate-cutting cycle will end with rates settling above the traditional neutral range, potentially between 3.25% and 3.5%. This would place rates about 100 basis points higher than the peak of the last cycle. The neutral rate is defined as the federal funds rate that stabilizes the economy under conditions of full employment and 2% inflation.
Estimates for the neutral rate have risen, from 2.5% in late 2019 to 2.9% in the latest economic projections. Goldman Sachs attributes this adjustment to higher bond market rates and updates in economic models, as well as strong fiscal spending and risk appetite, which are non-monetary factors.
The Federal Reserve's valuation of the long-term nominal neutral rate has increased from 2.5% in 2019 to 2.9%. This trend could persist due to changes in market forces and model data. Rising bond market rates support the notion of an increased neutral rate. As the bond market's forward rate is currently around 4%, it implies an expectation of higher future rates.
Furthermore, Goldman Sachs suggests some Federal Open Market Committee (FOMC) members may refer to model-based econometric estimates, which also indicate a rise in the neutral rate. The Federal Reserve's Tealbook briefing materials show that, by the third quarter of 2024, estimates place the nominal neutral rate between 2.8% and 4.6%, averaging 3.8%.
Non-monetary factors such as large fiscal deficits and strong risk appetites have also bolstered market demand, mitigating the economic effects of higher rates. Currently, the U.S. fiscal deficit as a percentage of GDP is about 5% higher than typical low unemployment periods. Despite tighter policies, financial conditions remain relatively loose with strong market risk preferences.
Due to these factors, Goldman Sachs analysts predict the Fed's final rate in this cycle will exceed the typical neutral range, potentially settling between 3.25% and 3.5%, marking an increase of approximately 100 basis points compared to the last cycle's peak.
