The Federal Reserve kicked off its rate cutting cycle in September of 2024 with a 0.5% rate cut and subsequently reduced the federal funds rate by 0.25% at the next two Federal Open Market Committee (FOMC) meetings, resulting in a full 1% reduction in short-term interest rates. Reductions in the federal funds rate typically result in similar changes to loans with variable interest rates, which includes lines of credit, credit cards, etc.
Following the December FOMC meeting, the Federal Reserve chair, Jerome Powell, disappointed markets by suggesting the Fed would pause rate cuts until they see more progress on inflation, which remains modestly above their 2% target. The December consumer price index (CPI) came in at 2.9%, having increased from its low of 2.4% in September.
Long-term interest rates
Despite a reduction of 1% in the federal funds rate, long-term interest rates have increased since the Fed began cutting the Federal Funds rate. The U.S. 10-year Treasury has increased by almost 1% since September. Most of the change in long-term interest rates can be attributed to an increase in term premium, which has increased by nearly 0.7% since September.
Term premium is the difference between the yields on long-term and short-term bonds. As long-term interest rates have increased, following Fed rate cuts, the term premium has been increasing. This means investors are requiring additional compensation to hold longer maturity bonds, such as 10- to 30-year maturities. Term premium of more than 75 basis points on U.S. 10-year Treasuries is the highest it has been since April of 2011.
Primary causes for this increase in term premium include:
- Higher inflation expectations, resulting in fewer federal funds rate cuts
- Large U.S. government deficits, resulting in more Treasury bond issuance
- The new administration’s plans for tariffs and the potential for a trade war
The potential for economic volatility in 2025 is high because of these risks. This is likely to keep term premiums and long-term interest rates elevated during the first half of 2025. Term premiums and long-term interest rates may begin to fall once investors have greater clarity on the likely outcomes associated with these key economic risks.
Soft landing rate-cutting cycles
A soft landing is a cyclical slowdown in economic activity that does not end in a period of negative growth or recession. So far, the Fed has successfully brought down the rate of inflation without creating a recession. In past soft landing cycles, it is not unusual for a central bank to take a pause before resuming rate cuts. Research by Goldman Sachs found that in 70% of soft landing rate-cutting cycles, central banks across the G10 have paused rate cuts for three months or longer.
The Fed’s dual mandate is to promote maximum employment and stable prices. Recent comments from the Fed chair suggest a renewed focus on price stability, or inflation. The Fed’s view of risk to its mandate has swung back toward price stability as the unemployment rate has stabilized in recent months.
The U.S. unemployment rate in December of 2024 was 4.1%, well above the low of 3.4% from April of 2023. However, the unemployment rate has improved from a recent high of nearly 4.3% to its current level, and the labor market remains stable with continued strong jobs growth. The stable outlook for employment will allow the Fed to pause interest rate cuts during the first half of 2025 and has led some analysts to question whether the next move will be a rate hike.
The case for higher interest rates
At the December Federal Reserve press conference, the Federal Reserve chair was asked if a possible outcome could be an interest rate hike in 2025. His comment was that in this world a rate hike could not be ruled out, but that a hike didn’t “appear to be a likely outcome,” and at close to 4.3%, interest rates were “meaningfully restrictive.”
The solid December jobs data combined with strong prices pressuring inflation have caused some analysts to begin forecasting interest rate increases. Analysts at Bank of America are suggesting the Fed’s interest rate cutting cycle has effectively ended and the next move could be to increase interest rates, “hikes will likely be in play if year-over-year core PCE inflation exceeds 3 percent and/or long-term inflation expectations become unanchored.”
The Personal Consumption Expenditure (PCE) report is the Fed’s preferred gauge of inflation. Core PCE is a measure of the prices consumers pay after excluding food and energy. Core PCE has increased from a low of 2.6% in June to 2.8% in November.
Conclusion
- The FOMC forecast suggests there will be two additional 0.25% rate cuts in 2025.
- Fed Fund Futures suggest there will be one additional 0.25% rate cut in 2025 and possibly a second.
The analyst community is becoming more mixed on their views of the future path of interest rates. Analysts at Goldman Sachs are still expecting two 0.25% rate cuts in 2025, both in the second half of the year, while analysts at Bank of America are suggesting the Fed may be through cutting rates and the next move could be to increase the federal funds rate.
Long-term interest rates, as measured by the 10-year U.S. Treasury, have a strong correlation with the federal funds rate. As a result, long-term interest rates are likely to remain higher until economic risks to the outlook clear and/or the Fed resumes interest rate cuts in the second half of the year.
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