Goldman: Market Underestimating Fed's Terminal Rate

While Goldman expects the Fed Funds rate to remain at zero through mid-2023, they see a rise to 3% thereafter, which is well above longer-term market pricing for the "terminal" rate (and the Fed's long-run median "dot" of 2.5%).

• They cite two key factors: one is the market's (and Fed's) underestimation of the r-star neutral real short interest rate, which has historically been around 1% but which is now seen by most as closer to zero.
• Secondly, they see it as possible that "if the Fed falls deliberately behind the curve in the context of a long expansion—r will likely need to rise above r*".
• The latter point echoes what ex-NY Fed Pres Dudley told MNI in April (when he said rates may have to rise to at least 3.5% and perhaps even >4%).
• Goldman believes "the uncertainty around the terminal rate is substantial and skewed strongly to the upside". That said, they say it "could take years before the market embraces this view", and is "more likely to come when the Fed ultimately discovers that it is able to keep raising the funds rate without generating a sharp tightening in financial conditions or a big slowing in activity".