Fewer Interest Rate Cuts Likely In 2025 Due To Continued Inflation

The Federal Reserve’s policy committee met today, December 18, 2024, and cut short-term interest rates by one-quarter of a percentage point. Long-term rates, such as on the 10-year Treasury bond, actually rose by 10 basis points (10 hundredths of a percent) because of the Fed’s own projections of few interest rate cuts in 2025. The inflation and employment outlook has changed significantly in the last few months. Business leaders should now anticipate very slow interest rate declines over the course of 2025.

Fed Sees Solid Labor Market and Stubborn Inflation

The Fed officials entered their meeting having seen a solid labor market. The jobs count rose every month this year. Although the rate of growth declined over the year, it ended up right in line with population gains. Some other indicators have shifted from very positive to moderately positive. The rate of voluntary quits declined but now sits at its long-term average. The number of open positions reported by employers declined but remains above anything seen prior to 2021. And the best leading indicator of the job market, the number of initial claims for unemployment insurance, rose a little over the year but remains 40% lower than its long-run average. So the labor market is neither booming nor busting, but closer to strong than to weak.

The Fed’s dual mandate is to keep employment strong and inflation low. But prices are still rising too fast relative to the Fed’s target, two percent as measured by the personal consumption expenditures price index excluding food and energy. Inflation has come down a great deal from its peak in 2022, but in 2024 it has remained stubbornly higher than target by about a half a percentage point. Wage rates are also rising and have even accelerated a bit in the past few months, up to four percent. Although wage increases do not cause general inflation, they do indicate inflationary pressure in the economy.

Trump’s Economic Policy And Federal Reserve Reaction

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Also entering the Fed’s consideration is the prospect for continued large deficit spending in 2025. In his press conference, Chair Jerome Powell said that some of the policy committee’s members expressly considered likely fiscal policy in making projections for the years ahead, some excluded policy changes from their projections, and some didn’t say whether they included or excluded policy changes. But certainly everyone who follows the economy has an opinion about likely fiscal policy in the second Trump administration. Incoming President Trump has created the DOGE to cut federal spending by two trillion dollars, but skepticism abounds. President Trump increased federal spending substantially in his first term of office, even before the pandemic. The Fed’s models are sufficiently Keynesian that continued deficit spending generates economic stimulus. And in the context of a fully employed economy, more stimulus will be inflationary.

Powell also said that the Fed would wait until specific tariff changes are made to analyze how they would impact the economy and inflation. Tariff changes would more likely trigger a one-time price hike than continued inflation.

Immigration policy did not come up at the press conference but should be weighing on policy-makers’ minds. If Trump tightens up entry across the border, as he did in his first term of office, population growth will drop from over three percent annually to half a percent or less. That will slow the growth of our productive capacity, which means the economy should get less stimulus from fiscal and monetary policy. Deportations could not just lower the growth of the economy but actually shrink it, though they seem unlikely on a large scale.

Why The Fed Will Slow Interest Rate Changes In 2025

Asked about why interest rates were cut in the face of economic strength and stubborn inflation, Powell said that policy is now well-positioned to either tighten or ease. He sees a balance between the risk of further inflation and the risk of weaker employment. “We see the risks as two-sided—moving too slowly and needlessly undermine economic activity in the labor market, or move too quickly and needlessly undermine our progress on inflation. So we’re trying to steer between those two risks.”

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My own guess is that the Fed gave financial markets guidance on what they would do, then watched the data move against them. The Fed painted itself into a corner and then decided that doing the wrong thing—cutting rates—would be a lesser mistake than disturbing financial markets and losing credibility with them.

Looking into the future, the projections of the 19 members show interest rates likely to drop by just a half a percentage point over the course of 2025. These projections are not a plan but rather members’ various expectations for how the future will evolve. They stand in contrast to the September projections that anticipated a full percentage point of decline in 2025.

Given the current state of the economy and inflation, as well as likely policy changes, I concur with the consensus of the committee. But Powell was wise to express humility about the Fed’s forecasting ability, a humility that I share. (Humility does not come naturally to me, but years of forecasting has helped it grow.)

Business Plans And Interest Rates In 2025

Business leaders looking at their 2025 plans may need to dial down expectations for declining interest rates. Plans that were set three months ago probably anticipated more cuts than will take place. This change will be especially important for companies connected to real estate, capital spending and big-ticket consumer purchases.

Contingency planning for a rise in interest rates makes sense, despite the Fed’s current expectations. Higher inflation could be triggered by greater spending stimulus due to continued deficit spending combined with slower immigration that limits productive capacity. That would lead the Fed to hike interest rates. This is less likely than the small rate cuts now expected, but certainly a possibility.