Could Federal Interest Rates Return to Zero?

Researchers at the Federal Reserve Bank of New York and San Francisco, including Fed Vice Chairman John Williams, have indicated that the Federal Reserve cannot assume its benchmark interest rate will not fall to zero again in the future. They found a 9% probability of the federal funds rate hitting the so-called "zero lower bound" in the next seven years.

What is the Zero Lower Bound?

The zero lower bound is a situation in which a central bank is unable to lower nominal interest rates below zero to stimulate the economy. This is often considered a significant challenge because traditional monetary policy tools become less effective.

Factors Influencing the Risk

The researchers noted that the current high level of uncertainty regarding interest rates is a significant factor in this risk. "Compared to the last decade, current data shows that market expectations for future interest rate levels are high," Williams and his co-authors wrote. "Nevertheless, due to the recent increase in uncertainty, the risk of the zero lower bound in the medium and long term remains significant, equivalent to 2018 levels."

They added that changes in interest rate expectations are the main driver of fluctuations in the risk of the zero lower bound, based on empirical data.

History of Zero Interest Rates in the US

Federal Reserve officials first lowered interest rates to a range of 0%-0.25% in December 2008 in response to the global financial crisis to stimulate economic growth. Interest rates remained in this range for seven years. Following the outbreak of the COVID-19 pandemic in 2020, interest rates were again lowered to zero and remained there for two years.

Goldman Sachs' Predictions

Economists at Goldman Sachs now expect the Federal Reserve to begin cutting interest rates in September, three months earlier than previously predicted. This adjustment is based on two main reasons: first, the impact of tariff policies on the economy this year is less than expected, while other deflationary forces are stronger; second, there are signs of a slowdown in the job market.

Goldman Sachs' chief U.S. economist, David Mericle, estimates the probability of a rate cut in September at "slightly above" 50%, and expects rate cuts of 25 basis points each in September, October, and December, as well as a 25 basis point cut each in March and June 2026. He noted that if the motivation for rate cuts is precautionary, successive rate cuts may be the most natural choice.

Goldman Sachs has also lowered its forecast for the terminal federal funds rate from 3.5%-3.75% to 3%-3.25%, well above the aforementioned zero lower bound.

However, Mericle said this does not reflect a change in the view of the economy's long-run neutral interest rate or economic conditions in the coming year, but because the impact of interest rates on the economy is limited, making the true neutral interest rate relatively vague. Whether the terminal rate is 3%-3.25% or 3.5%-3.75%, the economy is ultimately likely to achieve maximum employment and 2% inflation.