The Road to Neutral
As next week’s FOMC meeting approaches, we turn to our proprietary Fed funds model for insights into the likely path for US interest rates. Developed in the 1990s, the model analyses US capacity utilisation, unemployment, and inflation to predict the appropriate federal funds rate. While the neutral rate—or r-star—represents the interest rate that neither stimulates nor restricts growth, the model focuses on projecting short-term policy adjustments by analysing capacity utilisation and unemployment. At present, the federal funds rate remains above the neutral level, estimated at roughly 3%.
Capacity utilisation, a key indicator of economic slack, currently stands at 77.6%, below its historical average. This underutilisation signals room for economic growth without triggering inflation, providing scope for a more accommodative policy stance. With inflation expectations anchored at 2% and a real rate of 0.5–1%, the neutral rate is estimated at approximately 2.5–3%, serving as a benchmark for evaluating monetary policy. Historically, periods of below-average capacity utilisation have supported lower rates, as slack reduces inflationary pressures. While a pause in rate adjustments is likely in January, gradual cuts toward this neutral range seems likely as 2025 progresses.
The neutral rate is closely tied to capacity utilisation and unemployment, key inputs in our Fed funds model. While the model does not explicitly estimate the neutral rate, it aligns federal funds rate predictions with prevailing economic conditions, reflecting shifts in these metrics. Periods of high slack, for example, signal the need for lower rates, aligning policy with prevailing economic conditions.
Market expectations for 2025 broadly align with the model’s forecast for federal funds rate adjustments, which consider both economic slack and inflation trends. Despite the uncertainty surrounding fiscal policies under the current administration, the economy remains below the conditions needed for a neutral monetary policy stance. Monetary policy remains restrictive, with rates above neutral estimates. A pause during the January meeting would provide an opportunity for the Fed to evaluate incoming data and refine its outlook. Should inflation continue to moderate alongside subdued capacity utilisation, a gradual shift toward the neutral rate is expected as economic slack persists and inflation moderates. However, the transition will require careful calibration to prevent reigniting inflationary pressures or undermining growth.
Further Fed easing sets the stage for opportunities in fixed-income markets. Looking through the uncertainty of fiscal policies, higher-quality investment-grade emerging market bonds are particularly well-positioned to benefit from declining interest rates and stabilising global economic conditions. Mexican credit, in particular, looks attractively valued, offering compelling opportunities for investors looking for opportunities to diversify. These assets combine robust credit profiles with attractive yields, making them a compelling choice for investors looking for alpha opportunities. With risk sentiment likely to improve alongside monetary easing, 2025 offers a favourable environment for higher quality emerging market debt.
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