How Low Can Interest Rates Go? The Fed's Balancing Act in an Unusual Economy

Core Viewpoint - The Federal Reserve has cut interest rates for the first time in 2025, prioritizing a weakening job market over persistent inflation concerns, with further cuts anticipated [1][5]. Economic Conditions - Recent data indicates a significant weakening in the labor market, with non-farm payroll employment growth at approximately 0.5% year-over-year as of August, down from a previous estimate of 1% [3]. - Unemployment has averaged 4.2% over the past three months, slightly up from 4.1% in the first quarter, suggesting a stable but precarious job market [4]. Federal Reserve's Actions - The Fed is expected to implement two more rate cuts, bringing the federal funds rate down to between 3.5% and 3.75% by the end of 2025 [6][7]. - The Fed's projections indicate a potential for the federal funds rate to reach 3% to 3.25% by the end of 2026, aligning with market expectations [9]. Market Implications - The 10-year Treasury yield has decreased from around 4.4%-4.5% to just over 4%, contributing to lower mortgage rates, which is crucial for the struggling housing market [10]. - There are concerns that inflation could remain elevated if economic conditions heat up, particularly due to factors like AI-driven business investment and consumer spending [12][13]. Future Outlook - Inflation is expected to peak in 2026 but may decline rapidly thereafter, influenced by economic slack and labor market conditions [11]. - However, if inflation remains unanchored from the Fed's 2% target, it could necessitate a halt to further rate cuts or even a reversal of rates back to around 4% [13].