Fed Study Warns of Risk That Interest Rates Return to Zero

A scene from the floor of the New York Stock Exchange on Monday. (Spencer Platt/Getty Images)

The Federal Reserve’s benchmark lending rate, in a holding pattern since the start of the year and well above its pandemic-era level, could still fall sharply in the medium term, leaving the bank with little or no room to lower it in response to hard times.

New research from the Federal Reserve Banks of New York and San Francisco finds there is nearly a one-in-ten chance that interest rates will return to zero over the next seven years.

The analysis, published Monday, uses pricing from interest-rate derivatives tied to the Secured Overnight Financing Rate, or SOFR, to estimate how markets are thinking about the future path for rates. It shows that both lower expected rates and greater uncertainty increase the odds of eventually running out of room to cut.

The risk of hitting zero is low over the next two years, at roughly 1%. But it rises steadily over longer horizons, reaching 9% by 2032. That level is similar to what markets were pricing in back in 2018, when interest rates were climbing, but longer-term uncertainty about the economy’s trajectory remained high.

The research, co-authored by New York Fed President John Williams, tracks how the risk of reaching the zero lower bound—the point where interest rates are at or near zero—has changed over time. It turns out that the probability tends to rise when economic uncertainty increases.

Right now, even as investors expect rates to remain around 3% to 4% over the next several years, the current level of volatility in the outlook is keeping medium-term risks elevated.

Renewed concerns over economic uncertainty—the fallout from President Donald Trump’s latest tariff announcements, growing geopolitical tensions, and uncertainty about the future of Fed leadership —all add to a cloudier picture for investors. While the report doesn’t directly model those risks, the authors note that shifts in policy uncertainty can quickly alter market expectations and increase the probability of reaching the lower bound.

For the Fed, the findings highlight how little policy space may be available over the longer term, despite rates currently sitting well above zero. Deeper structural forces and persistent uncertainty could limit how much room there is to cut when the next downturn arrives.

Write to Nicole Goodkind at nicole.goodkind@barrons.com