Interest Rate Outlook for 2025: Three Scenarios

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The Federal Reserve recently announced a reduction in the federal funds policy interest rate by 0.25 percentage points, adjusting its forecast for rate cuts in 2025 from four to just two. This decision, while anticipated, led to unexpected reactions in financial markets, resulting in a significant selloff in bonds, stocks, and gold, alongside a rise in the dollar.

The more surprising aspect may be the potential for fewer rate cuts next year, or possibly none at all. Fed Chair Jerome Powell indicated in a press conference following the December Federal Open Market Committee (FOMC) meeting that a rate hike cannot be entirely dismissed, even if it is not the most probable scenario.

If the Fed does decide to lower rates in 2025, it is likely to occur later in the year. Early in the year, liquidity conditions may improve due to the Treasury’s cash management rather than direct Fed actions.

Currently, monetary policy is significantly less restrictive than it was a few months ago. The FOMC’s updated target range for the federal funds rate is now between 4.25% and 4.50%, a decrease of one full percentage point since the initial cut in September. The new target for the end of 2025 is set at 3.9%, an increase from the previously anticipated 3.4%, which is only 90 basis points above the new neutral rate estimate of 3%.

A year ago, the midpoint of the federal funds target was 5.3%, more than double the neutral rate of 2.5%. The neutral rate, however, remains a somewhat subjective measure, akin to the Supreme Court’s definition of obscenity: it is recognized when seen.

Concerns about inflation, driven by a growing federal deficit and potential tariffs from the incoming Trump administration, suggest that the anticipated two 25-basis-point cuts may not materialize. Additionally, Apollo’s chief economist, Torsten Sløk, noted a 40% chance of a Fed rate hike in 2025.

In the short term, liquidity conditions may improve for technical reasons, heavily influenced by the federal government’s debt ceiling, which is set to be reinstated at the beginning of the year. If the debt limit is reimposed, the Treasury will need to deplete its cash reserves to meet obligations, effectively injecting money into the economy.

Strategas’ Washington research team, led by Daniel Clifton, recently estimated that a drawdown of the Treasury’s cash balance could create a “liquidity bazooka,” similar to those seen during the March 2023 bank rescue and in November 2023. With the Fed likely to maintain its current stance, these improved liquidity conditions could further reduce the necessity for rate cuts in early 2025.

However, this liquidity boost will not occur if the debt ceiling is raised, as noted by the Strategas team. President-elect Donald Trump has advocated for a debt-ceiling increase, but this has become entangled in congressional negotiations over new spending authorizations, which are due by December 20.

The shift in Powell and the FOMC’s tone reflects the reality that the economy may not require immediate rate cuts. The FOMC’s projections indicate that its preferred inflation measure, the personal consumption expenditures price index, is expected to end 2025 at 2.5%, still above the Fed’s target of 2%.

Moreover, the FOMC projects real GDP growth of 2.1% for 2025, a slight increase from the previous estimate of 2.0%. This adjustment follows a significant upward revision of the third-quarter GDP growth to an annualized rate of 3.1%, primarily due to stronger consumer spending. The Atlanta Fed’s GDPNow estimate for the fourth quarter also rose to 3.2%.

The Powell-led Fed has faced challenges, having misjudged the post-pandemic inflation surge as temporary, which led to prolonged ultra-stimulative policies. This was followed by rapid rate hikes starting in 2022 and a notable half-point cut in September. Additionally, the Fed’s substantial balance sheet continues to exert downward pressure on long-term interest rates.

The economy is currently growing at a pace that exceeds the FOMC’s potential growth estimate of 1.8%. Inflation remains above the Fed’s target, while unemployment aligns with the committee’s long-term equilibrium estimate of 4.2%. Financial conditions are robust, characterized by high equity valuations and narrow credit spreads. The new administration’s policies are expected to further stimulate growth and inflation.

In light of these factors, it is plausible that the anticipated pause in rate cuts could persist throughout 2025. Regarding potential rate hikes, Powell acknowledged, “You don’t rule things completely in or out in this world.”

For further information, please contact Randall W. Forsyth at randall.forsyth@barrons.com. To subscribe to Barron’s, visit [http://www.barrons.com/subscribe]