Fed may leave rates alone next year

It seems like the Federal Reserve didn’t cut interest rates much this year, as it didn’t start until September and issued many cautious statements.

But it actually exceeded its own expectations for rate moves. The central bank has lowered the federal funds rate target by 100 basis points to 4.25-4.5%. That topped Fed officials’ forecast of about 75 basis points last December.

The Fed acted as inflation eased toward its target of 2% and employment growth slowed. Another key factor that doesn’t get much media attention is the Fed’s quest for a neutral fed funds rate – one that doesn’t push the economy to excessive growth or inflation.

By the time of the Fed’s final 2024 rate reduction in December, inflation had stopped sliding, and economic growth showed resilience. So pushing the fed funds rate toward neutral seems to have been a major reason for the December move.

The issue now is what the Fed will do next year. Its officials predict about 50 basis points of rate decreases next year. But that’s no slam dunk. 

Economic growth & inflation

The economy continues to chug along: the Atlanta Fed’s GDP forecast model shows annualized growth of 3.1% for the fourth quarter. Meanwhile, the Fed’s favored price index showed annual inflation of 2.4% in November, exceeding its 2% target. And if the U.S. imposes tariff increases, that could send inflation higher.

So it’s easy to conceive that the Fed will cut less than 50 basis points. Esteemed economist Torsten Slok of Apollo Global Management sees only a 40% chance that the Fed will cut rates at all next year.  

As for long-term rates, they actually rose this year, with the 10-year Treasury yield up 72 basis points at 4.59%. As long as the economy remains strong and inflation remains a threat, long-term rates are likely to stay steady or move higher. 

The exploding government budget deficit also could push long rates upward. That’s because a rising deficit means the Treasury has to issue more bonds to pay for it, And the increased issuance means higher rates.

Turning back to the Fed, coming into 2025, it finds itself between a rock and a hard place. If it cuts rates, it risks igniting inflation. But if it doesn’t, it risks an economic slowdown. 

For traders and investors, assessing Fed policy on a quarterly basis may be a good way to navigate its effect on the markets.