When the Federal Reserve jolted markets in December, it wasn’t with its decision to cut interest rates by a quarter point, but with big changes in its rate forecasts for 2025.
Fed officials indicated they now expect to cut rates by just a half point in 2025, which would likely mean two rate cuts at their eight policy-setting meetings. That’s down from predicting a full percentage point (or four quarter-point cuts) in their September projections.
Two quarter-point cuts would bring the target federal-funds rate down to a target range of 3.75%-4.00%. Some analysts are predicting even fewer cuts than that (or no cuts altogether) amid political and economic uncertainty. “A skip in January could very easily turn into an extended pause,” says Roger Hallam, global head of rates at Vanguard. “Our view is that [the Fed] probably do have one more [cut], but pauses at or above 4%” in 2025.
Against this backdrop, another scenario becomes possible, if unlikely: A strong economy and renewed rise in inflation could prompt the Fed to raise rates again in 2025.
Treasury Yield and Federal-Funds Rate
Source: Federal Reserve Economic Database.
An Uncertain Interest Rates Policy Outlook
After maintaining a “higher for longer” interest rate stance for much of 2024, the Fed cut rates by a dramatic half of a percentage point in September. That was followed by two more 25-point cuts in November and December.
For a moment this fall, it looked like the central bank was ready to slash rates relatively quickly amid strong progress on inflation and ongoing strength in the labor market. In September, central bankers anticipated roughly a full percentage point of easing in 2024 (one 50-point cut and two 25-point cuts), and another full percentage point of easing in 2025 (four additional 25-point cuts). But now it looks like Fed officials are ready to hit the brakes.
Investors can look to a slew of factors to explain the new outlook. Inflation is proving stickier than expected, and GDP growth remains strong. The labor market has remained relatively healthy. Policies expected under the incoming Trump presidential administration (tariffs, tax cuts, deficit spending, etc.) could worsen inflationary pressures. But President-elect Trump hasn’t taken office yet, and it’s unclear to what extent his campaign promises will be implemented.
“The Fed is going to be struggling with the same thing you or I are struggling with, which is the range of policy outcomes for next year is wide,” says Don Rissmiller, chief economist at Strategas. “You have fiscal policy, you have trade policy, you have regulatory policy, all of which could be different.” These aren’t explicitly the Fed’s responsibility (that’s monetary policy alone), but he says they “affect the economy, unemployment, and inflation. Those are their mandates.” Rissmiller’s takeaway from the Fed’s new projections is that they’re unsure what the future will bring. “I don’t think they want to commit to a monetary policy without knowing the answer on some of those other policies,” he explains.
A New Neutral
Underpinning the debate about rate cuts is the idea of a neutral interest rate—one that neither slows nor stimulates the economy. A neutral rate keeps inflation low and stable while maintaining full employment. It can’t be measured directly, but economists can make inferences about whether rates are close to neutral based on how the economy behaves.
Since the economy continued to grow strongly and the labor market remained healthy even as Fed officials raised rates dramatically to combat inflation, many analysts have suggested that the neutral rate is higher than previously thought. Some have estimated the nominal neutral rate, which does not account for inflation, to be about 1%. That would mean a 3% real neutral rate, assuming an ideal world with 2% inflation. Some analysts argue that it’s higher.
In the press conference after the Fed’s December meeting, Chair Jerome Powell said that while rates are still restrictive, they’re getting closer to that theoretical level of balance. That’s “another reason to be cautious about further moves,” he said. The Fed wants to avoid cutting rates too much and allowing inflationary pressures to strengthen again.
Rissmiller suggests that in a world where inflation is closer to 3% and not 2%, a federal funds rate of around 4% wouldn’t be far from neutral. “I could see them pausing there for a while,” he says.
“If I were a betting man,” says Hallam, “I would say that that neutral ‘dot’ still has [room] to drift higher [than the 3% the market is pricing].”
Morningstar’s senior US economist Preston Caldwell opines: “Given the uncertainty about the neutral rate and the vague sense that the federal-funds rate is getting closer to it, the Fed is virtually certain to slow the pace of rate cuts in 2025 to better gauge the effects of monetary policy.”
Are Rate Hikes on the Table?
As questions about the path of Fed policy continue to circulate, some market watchers are even floating the idea that the central bank might raise rates in 2025—especially since growth is expected to be strong next year, and some of the incoming Trump administration’s potential policies are likely to exacerbate inflation.
Rissmiller doesn’t see this as likely. He says that to consider raising rates, central bankers would need more confidence that the unemployment rate will stop rising. “That’s the missing variable.” He explains that a small uptick in unemployment would bring the unemployment rate up to 4.3%—a new high in this cycle. He adds that considerable research shows that once the unemployment rate starts rising, it tends to keep going. That would be bad news for the Fed, which has been adamant that it does not want to damage the labor market as it fights to bring inflation back to target.
US Unemployment Rose in 2024
Source: Bureau of Labor Statistics.
Hallam says that while rate hikes in 2025 are not impossible, they are also far from his central case. “As long as the Fed can still have reasonable confidence the policy is restrictive, and that in the medium term, inflation will head toward 2%, their bias will be neutral to easing,” he explains.
Will the Fed Cut Rates in January?
As of late December, markets saw a roughly 89% chance that the Fed will hold rates steady at its next meeting in January, according to the CME FedWatch tool. Traders saw a roughly 11% chance that central bankers will cut rates by another 0.25 percentage points.
Federal-Funds Rate Target Expectations for January 29, 2025 Meeting
Source: CME FedWatch Tool.
But projections from futures markets (and the Fed itself) should be taken with a grain of salt. Rissmiller reminds investors that much Fed forecasting is “analysis with incomplete information.” He explains: “That’s the challenge with drawing big conclusions right now. Even if the Fed says in their dot plot projections that next year is two cuts, that doesn’t mean next year is two cuts. It just means that’s the current thinking.” He thinks it would not be shocking to see those projections change again in the next quarter.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
