Next week’s meeting of the Federal Open Market Committee will set the tone for the markets for the next several months. In one sense it may be a non-event:  investors have coalesced around the view that the central bank will cut the main policy rate by 25 basis points to 4.25-4.50%. This would push government-oriented local government investment pool rates to the 4.25% range while prime-oriented pool rates should settle in about 15 basis points higher than this. Investments purchased to fund separately managed fixed income portfolios with maturities of one-five years and bank deposits are likely to offer current yields in the same range.

The pace of subsequent cuts is uncertain. If the economy continues along its current trajectory—real growth of 2-2.5%, inflation within range of the Fed’s two percent target, and the job market solid but not screaming strength as it was six months ago, the Fed could continue to ratchet rates lower, but the frequency of cuts could slow.

• How much lower is hard to discern. Investors seem obsessed with when the Federal Funds rate will reach the “neutral rate” for monetary policy—that is the (somewhat mythical) rate that is neither restrictive nor stimulative—even though most economists believe the neutral rate is only observable after the fact. This is not reassuring to people who are not economists for a simple reason: if you’ve ever tried driving a car by looking through the rear view mirror you know that the information you gain even with keen observation is of very little use in navigating.
• There’s great anticipation/excitement/concern about the effect that Trump’s tax, tariff, and trade policies might have on rates, but how they might influence Fed policy is unknown. Moreover, it’s not likely that they will affect that policy before the second half of 2025—an eternity for most investors in the short-term markets. That’s because Jerome Powell, chair of the Fed, has been quite vocal in stating that the central bank does not set policy based on modeling or anticipating future actions. Rather, it responds to actual market and economic developments. So, expect the Fed to fall behind the markets, just as it did in 2022 (when investors pushed up rates much faster than the central bank tightened monetary policy.) 
• Left to its own the market can be a terrible predictor of Fed policy and the interest rates that result. To see this, look no further than the market reaction to the Fed’s surprising 50 basis point cut in the Federal Funds rate at its September meeting. The announcement contained this language: “In considering additional adjustments to the target range for the federal funds rate, the [Federal Open Market] Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.” And it was accompanied by release of the quarterly Summary of Economic Projections that showed the median level for Federal Funds was expected to be 4.40% at the end of 2024 and 3.40% at the end of 2025.

Ignoring  this seemingly clear message from the central bank that policy would be eased at a modest pace, investors pushed rates on forward contracts sharply lower, to 2.85% at the end of next year. The chart at the top of this post (red bars) graphs the result the day after the Fed meeting.

Since that meeting investor sentiment has changed to the point where futures contracts now forecast a more modest decline, to the level of approximately 3.75% at the end of next year  

 Since other short-term rates closely track the outlook for near-term monetary policy, they too respond to sentiment as much as they do to reality. 

So the accompanying chart of two-year Treasury yields—here compared with the actual Federal Funds rate—has tracked higher while the Federal Funds rate has adjusted lower over the past several months.

Does this matter? In the long run, of course, the level of interest rates matters to public agencies a great deal as it affects their borrowing and investment rates. Remember 2020? Short term rates near zero meant that investment earnings were not much more than a rounding error in most public agency budgets. By last year they were 20 to 25 times higher. But how important should they be in steering the day-to-day strategies for a public sector portfolio? It’s appropriate to observe that few investors, no matter what their pedigree, have long-term records of correctly betting on the direction of interest rates.  And to observe as well that the vast majority of public agency investment policies put “Y” at the end of the SLY acronym. Safety and liquidity come first.