A New Chapter
For 2025, the financial markets will be entering a new chapter in the ever-evolving policy story. Indeed, not only will the U.S. economy be operating under a new political and attendant fiscal backdrop, but it will also be in the midst of a different monetary policy setting—rate cuts, not the after-effects of rate hikes.
Interestingly, for the first time in a couple of years, there isn’t a wide debate about when—rather than if—a recession could be forthcoming. Conventional wisdom seems centered around a modest growth landscape. The continued resiliency of the labor market has been supporting this outlook. While job growth has cooled off a bit, the latest three-month moving average for total nonfarm payrolls still came in at a nice clip of +173,000, providing continued support for consumer spending.
Another expected area of support for growth could come from continued spending on artificial intelligence (AI) investment. Residential outlays could prove to be a bit trickier. While expected Federal Reserve (Fed) rate cuts seem supportive on the surface, if the U.S. Treasury (UST) 10-Year yield remains above 4%, elevated mortgage rates may serve as an offsetting factor.
While some slowing in the pace of growth from its current pace of just under 3% is expected, real GDP with a low “+2%” handle appears to be a reasonable case scenario.
"The U.S. economy will be operating under a new political and attendant fiscal backdrop, but it will also be in the midst of a different monetary policy setting—rate cuts, not the after-effects of rate hikes."
Inflation…a Bumpy Path
After exhibiting a renewed bout of disinflation through the spring and early summer of 2024, the improvement in price pressures appears to have hit a roadblock in recent months. Core CPI has been stuck in the 3.3% vicinity throughout the fall and has created some trepidation for the markets about the prospects for further progress.
Investors witnessed a similar development to begin 2024 before disinflation re-emerged as the prominent trend. This brings us to the question of whether the “last mile” toward the Fed’s 2% goal will actually take a lot longer than originally expected (if it is achieved at all) or, as Chair Powell has characterized inflation, it will be a “bumpy” path.
Either way, the 2% target seems to lie further out on the horizon, with readings as of this writing still well above pre-COVID-19 inflation levels.
Fed Policy “Recalibration”
After much anticipation, the financial markets finally got their rate cut, in fact 100 basis points (bps) worth in 2024. Those easing moves are now in the rearview mirror and the 2025 outlook for U.S. monetary policy has become a little less clear. The narrative surrounding the scope of policy easing has shifted dramatically since mid-September, as the labor market is apparently not cooling as much as envisioned, and inflation is again proving to be somewhat sticky in recent months. While further rate cuts are still on the table for the New Year, the Fed seems to be shifting to ‘pause’ mode to begin 2025.
Fed Chair Powell has reiterated that policy has been “recalibrated” with the goal of becoming less restrictive and moving the Fed Funds target down to neutral territory, data permitting. That’s where the uncertainty comes in. What is a neutral Fed Funds Rate? Based on the Fed’s most recent median estimate, the level stands at 3.00%. In our opinion, the level is now higher than that reading, and at a minimum, could be at least 3.5%. Powell & Co. seem to be operating under a similar assumption, for the most part, but what the policy makers decide is the appropriate level may be a moving target in the months ahead.
If the voting members follow through on bringing the Fed Funds target down to the aforementioned neutral reading and stop easing there, that would mean there could potentially be only a couple of rate cuts for 2025. In addition, quantitative tightening (QT) is apt to be revisited and could come to an end in 2025.
The bottom line is that if the labor market/inflation data continue to come in as they have recently, the rate cut path will become very murky. The policymakers have already cut rates by 100 bps, so perhaps Powell & Co. ‘taking stock’ makes sense.
"While further rate cuts are still on the table for the New Year, the Fed seems to be shifting to ‘pause’ mode to begin 2025."
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