The Federal Reserve – How Should Investors Form Interest Rate Expectations?

Investors across the globe look at the Federal Reserve’s every move to calculate where short-term and long-term interest rates will go in the future. The Fed utilizes open market policy/operations to provide a range of where they think short-term interest rates should be. This policy directly affects the short end of the yield curve.  The Federal Reserve meets several times a year to set this policy. The policy path is based on inflation data, employment data, and the overall health of the economy. The Fed has a dual mandate which is to promote stable inflation through a 2% per year inflation target and ensure stable employment.  “Stable employment” is an undefined metric.

During their policy meetings, voting members of the Federal Open Market Committee decide on an interest rate policy and give a statement on their view of the economy.  Most laypersons just see the headline adjustments to the Fed Funds Rate.  However, there is much more contained in the policy statements that professional investors parse through to develop a macroeconomic thesis.  A few times out of the year, the Fed also publishes a survey from the voting members that show the projected Fed Funds Rate over the next several years; also known as the “dot plot.”

The current summary of economic projections (published 9/18/2024) shows the 2025 Fed Funds Rate at a range of 2.875% – 4.125% according to the voting members.  As of the writing of this article, the current Fed Funds Rate is at 4.75% – 5.00%.   So, we can say that the Fed believes that the Fed Funds Rate will be 0.875% – 2.125% lower than they are right now in 2025.  This helps form investor expectations on where interest rates will go.  The average observer will be led to infer that interest rates are going down over the next twelve months.  When looking out further to 2026 and 2027, we see the average Fed Funds at a range of 2.25% – 3.75%.

Why does this matter? Obviously, their projections could change as future uncertainties around inflation and employment varies as data comes in. However, the projections reveals the current bias of the voting members as to where their future expectations for interest rates lie and thus moves the interest rate markets either up or down depending on the stated policy.  The tighter the grouping of the projection, the more united the members are around a certain policy and the higher the probability of that policy occurring.  The wider the grouping in the dot plot, the wider the variation in expectations.

Since interest rates are a derivative of inflation and employment, the members are analyzing economic results in these two categories.  Surprises in information as it relates to inflation or employment will also move the interest rate markets.  Market and Fed economists form expectations around inflation and employment based on several factors.  These expectations form a consensus amongst the economists which acts as a benchmark for future data readings.  Deviations outside of consensus expectations could drive interest rates up or down.

At a minimum, investors should be looking at and understanding inflation and employment data to form expectations for the path of interest rates and comparing them to the Fed projections.

Here are three links to three resources we use on inflation, employment, and interest rates to help us form our expectations for interest rates:

Fed Calendar and FOMC Meetings: The Fed – Meeting calendars and information

CPI and PCE Inflation Data (BLS): CPI Home : U.S. Bureau of Labor Statistics

National Employment Data (BLS): CPS Home : U.S. Bureau of Labor Statistics