What Is the Terminal Rate?
What is the terminal rate? It is the level where a central bank’s interest rate is expected to stop rising: the top of the hiking cycle. When a bank is cutting, traders use the same idea for the floor.
The number traders mean is the market’s. It is read from the pricing of interest rate futures and swaps, and it shifts with every inflation report, jobs report and speech. The Fed’s dot plot shows the committee’s own view of the peak, which need not match the market’s. Who sets the rate at each bank is on The central banks.
Why the end point matters more than the next hike
By the day of a meeting the next hike is usually priced. Traders have seen it coming for weeks, so the decision itself rarely surprises. What can still surprise them is how far the whole path goes.
Imagine, with invented numbers, that the market expects the Fed to stop at 4.50% and the ECB at 2.50%. Two US inflation reports in a row come in above the forecast. The Fed’s expected peak moves to 5.00% and the ECB’s stays put.
Neither bank has done anything. Yet every Fed meeting between now and the peak has just been repriced, and the expected gap between the two rates is half a point wider. That tends to weigh on EUR/USD. Today’s gaps are on Interest rate differential by currency pair.
How far the peak can travel: the Fed in 2022 and 2023
In September 2022 the median Fed participant saw the rate peaking in 2023 at 4.6%, a range of 4.50–4.75%. Three months later that median was 5.1% (December 2022 SEP). The committee had moved its own peak up by half a point in one quarter.
The actual top came on 26 July 2023, when the Fed raised its range to 5.25–5.50% (FOMC statement). That was a quarter point above even the December dots. The rate sat there until 18 September 2024, when the Fed cut by half a point to 4.75–5.00% (FOMC statement).
The dots have erred both ways. Take the highest median on each dot plot and set it against the top the rate actually reached (the SEPs, and the target range on FRED). In the cycle that began in December 2015, the Fed published 13 dot plots up to its last hike in December 2018. Twelve put the peak above the 2.25–2.50% where the rate stopped, three of them in 2018 at 3.4%. One, in June 2016, matched it.
In the cycle that began in March 2022, the first five dot plots all put the peak below 5.25–5.50%, starting from 2.8%. The first to reach it was June 2023, at 5.6% (June 2023 SEP), the meeting before the last hike. Two cycles is a small sample, but in both the committee’s own peak kept moving until the end.
Each of those revisions to the peak repriced every meeting in between at once. If you watched only the size of the next step, you looked away from the part that kept moving.
How a central bank says it has arrived
Banks rarely announce the peak in so many words. On 14 September 2023 the ECB raised its deposit rate to 4.00% and said its rates “have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target” (ECB press release).
Read that as: we are probably done, and the question now is how long we hold. It was the top. The next move was a cut to 3.75% in June 2024, “after nine months of holding rates steady” (ECB press release). A shift in that kind of wording is what traders mean by a dovish turn.
How it differs from the neutral rate
The neutral rate is the level that neither speeds the economy up nor slows it down. The terminal rate is where this cycle tops out. When inflation is the problem, the peak sits well above neutral, on purpose.
In December 2022 the Fed’s longer-run dot, the nearest thing its participants give to a neutral rate, was 2.5%. The median for 2023 was 5.1% (December 2022 SEP). That gap of 2.6 points is how hard the committee meant to lean on the economy.
Comparing two currencies
The terminal rate is most useful in a pair. A pair tends to move with the gap between the two expected peaks. When both peaks rise together, the gap stays put, and rates give the pair little new to go on.
The priced peak is not a forecast that has to come true; even the Fed’s own moved half a point in a quarter. When a release shifts one expected peak and the pair barely reacts, something else is driving the pair, and it is worth finding out what.