Kiplinger Interest Rates Outlook: The Fed Is Still Committed to Gradual Cuts

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The Fed lowered its short-term interest rate by a larger-than-expected 0.5 percentage point on September 18, from 5.25% to 4.75%. Fed Chair Powell offered three reasons during the press conference as to why the cut was so large:

• “We made a good, strong start because of our confidence (that inflation is coming down);” 
• “We wanted to keep the labor market in good condition;” and 
• "The size of the cut is a sign of our commitment not to get behind."

Certainly, a large first cut followed by smaller ones in the future will be judged to be reasonable. And Powell is correct that inflation has been trending down, while there have been signs of modest weakening in the labor market. But, while these factors likely played a part in the decision, it seems that Powell is also still smarting from the criticism that the Fed received back in 2022 when they were late to raise interest rates to fight inflation in the first place, and he is determined not to be late on the downside of inflation, as well.

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The Fed remains committed to gradualism. Expect future meeting cuts to be only a quarter-point each unless the economic situation worsens. The Fed’s “Summary of Economic Projections [PDF],” which it also released at the policy meeting, indicates that the Fed is not likely to repeat September’s large cut. The members of the Fed’s policy-making committee indicated that most saw only quarter-point cuts at one or both of the next two meetings, which will take place on November 7 and December 18.  

Once the Fed does start cutting interest rates, it will likely continue doing so into 2026, but will not return short-term rates to zero. Figure on the one-month Treasury bill’s yield falling to about 3.0%, and the bank prime rate ending up around 6.0%, down from the current 8.0%, after the Fed has finished reducing its benchmark rate.

Long-term rates are likely to stay in the 3.5% to 4.0% range for a while. As short rates come down, long rates will not move in lockstep, because a faster-growing economy could stoke inflation fears among bond investors. There is also the pesky matter of the continuing inverted yield curve, the abnormal situation in which long-term rates are below short-term rates. Eventually, we expect that the yield curve will revert to upward-sloping, with long-term rates above short-term rates. 

The Fed is continuing to reduce its Treasury securities portfolio, even with the half-point rate cut. Powell has emphasized that it is still the Fed’s goal to lower the overall amount of Treasuries and mortgage-backed securities it holds, in order to get its portfolio back to an historically more normal level.

30-year mortgage rates are likely to dip under 6% for the first time in two years, and 15-year mortgages under 5%, after the Fed’s cut. Continued progress on lowering inflation this year could result in a further decline of a few tenths of a point on home loans. Mortgage rates are still higher than normal relative to Treasuries because the recent rise in short-term interest rates crimped lenders’ profit margins on long-term loans. The eventual Fed cuts in short-term rates will boost banks’ lending margins and should bring some extra reduction in mortgage rates, too. 

Other short-term interest rates will come down at the same pace as the Federal Funds rate. For investors, rates on super-safe money market funds will be slipping below 5%. Rates for consumer loans will improve. Rates on home equity lines of credit are typically connected to the prime rate (now 8.0%), which in turn moves with the Federal Reserve’s benchmark rate. Rates on short-term consumer loans such as auto notes will also be affected, with vehicle financing rates going below 7.0% for six-year loans to borrowers with good credit.

Corporate bond rates have also moved down in tandem with Treasury rates, thanks to the decline in inflation and decreasing recession fears. AAA-rated bonds are now yielding around 4.2%, BBB bonds 4.9%, and CCC-rated bond yields are around 12.3%.

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