Fed paper says risk of falling back to near zero rates still in play

Yahoo

07-07-2025

By Michael S. Derby
(Reuters) -The prospect of the Federal Reserve once again setting its short-term interest rate target at near zero levels at some point in coming years remains real despite current relatively high levels of short-term borrowing costs, a new paper published jointly between the New York and San Francisco Federal Reserve banks said.
The medium- to long-term risk that the central bank's interest rate target will return to super low levels 'is currently at the lower end of the range observed over the past fifteen years,' said a paper that counted New York Fed President John Williams as a co-author. It was published on Monday. But the researchers added the chance of a return to near-zero rates 'remains significant over the medium to long term…due to recent elevated uncertainty.'
A near-zero federal funds rate target is associated with troubled economic times and their aftermaths. The Fed pegged its short-term interest rate target at such levels from 2008 and the onset of the financial crisis until late 2015, and found itself again at such levels in March 2020 due to the COVID-19 pandemic, before hiking interest rates aggressively starting into the spring of 2022 to combat the worst inflation readings seen in decades.
A near zero level for the interest rate target the Fed uses to achieve its job and employment mandates creates substantial challenges for central bankers. To provide stimulus beyond what a super low target can provide, officials have had to turn to controversial bond buying programs aimed at lowering long-term rates, which have in turn massively increased the size of the Fed's balance sheet. The Fed has also had to resort to communications strategies which officials also hoped would bolster the stimulative power of low rates.
The recent chapters of hitting near-zero rates came during what had been a multi-decade trend of declining rates amid a long-running trend of declining inflation pressures.
The experience of the last few years has ushered in a new landscape for the central bank. High levels of pandemic-driven inflation have cooled considerably. But the Fed, at a current target rate of between 4.25% and 4.5%, is still at a level that is relatively high relative to recent years' experience. It also faces considerable uncertainty over the outlook due to trade policy.
As of June, Fed officials expected to cut their target to 3.4% by 2027 and to start on that path this year. The central bank is also being pressured by President Donald Trump for aggressive easings.
Meanwhile, officials have also been revising up the forecast of the rate that's neutral relative to the economy's performance. Now at 3%, that projection as well as the June forecasts suggests the Fed may have more of a buffer to cut rates without hitting zero relative to recent years.
The paper, which based its analysis on interest rate derivatives, noted that even with the current buffer, the interest-rate outlook is complex. The risk of hitting near-zero rates 'tends to fall with higher expected levels of interest rates and tends to rise with interest rate uncertainty," the authors wrote.