As financial markets face uncertainty over when the US Federal Reserve will begin cutting interest rates, an even bigger question may be when and where central bankers plan to stop.

After rapidly hiking rates 525 basis points between March 2022 and July 2023, the Fed is now weighing its first cuts since March 2020, when it lowered its benchmark federal funds rate to near zero as the COVID-19 pandemic began. A majority of the futures market now expects the Fed to start with a 25 basis-point rate cut at its June meeting, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.

When those reductions begin will ultimately hinge on whether inflation falls to the Fed's 2% target and whether one of the hottest domestic labor markets in decades cools. The prospect of cuts this year is also increasingly adding attention to questions of just how deep the Fed will ultimately cut and whether the central bank's post-pandemic rate hike cycle has effectively ended the era of low interest rates.

"Incoming inflation data will certainly have the greatest influence over Fed policymakers' deliberations, and there is a risk the first cut arrives later than we and the market anticipate if inflation remains buoyant," said Oren Klachkin, a financial market economist at Nationwide. "It's far from clear where the 'new normal' or neutral rate is, but this won't stop the Fed from loosening policy later this year."

The new normal

The futures market is betting that the federal funds target will still be above 3.5% in July 2025, according to the CME FedWatch Tool. That would be about a full percentage point above where it was roughly a year before the pandemic hit.

The median view among the governors and reserve bank presidents in the rate-setting Federal Open Market Committee is that the longer-run federal funds rate will be 2.5%, according to quarterly economic projections released after the Fed's December meeting.

While that projection is in line with the median view among Fed officials from December 2019, some have boosted their expectations. Three of the 19 FOMC members forecast a longer run rate of 3.5% or higher in December 2023, while no member projected a rate above 3.25% back in 2019. Those projections will be updated after the Fed's next meeting on March 20.

Fed Chairman Jerome Powell has indicated that the central bank is not targeting a specific level for longer-term rates and said the path forward will depend on many factors.

"Ultimately, you only know when you get there and by ... the way the economy reacts," Powell said during a September 2023 press conference.

While the Fed still sees the neutral rate around 2.5%, it is likely closer to 3% to 3.25% in an environment of large fiscal deficits and high government debt levels, said James Knightley, chief international economist at ING.

"Loose fiscal policy will need to be offset by tighter monetary policy if the Fed is serious about maintaining inflation at 2%," Knightley said.

No cuts in 2024?

Where rates are headed could depend on how much of a need the Fed sees to cut, said Torsten Slok, chief economist at Apollo. While the futures market may anticipate cuts beginning in the summer, Slok believes the Fed will not reduce rates at all this year.

"The economy is simply not slowing down," Slok said. "And the Fed pivot in December 2023 has eased financial conditions and given a tailwind to growth and inflation."

US consumers have become less vulnerable to rate hikes with about 90% of consumer debt fixed rate, Slok said. In addition, large firms also have significant fixed-rate debt, lessening the sting of relatively high rates on the corporate world.

"So the bottom line is that it requires rates higher for longer to get inflation under control," Slok said.

Rates could stay high for much longer than the market currently expects, and "the jury is still largely out," on whether rates will return to the lows seen before the pandemic, said Klachkin with Nationwide.

"One's view of the neutral rate today is driven principally by whether they think the pandemic caused enduring, structural changes in the economy," Klachkin said. "We think this remains to be seen since the economy is still emerging from the effects of COVID."