The Federal Reserve Policy Committee met today, December 18, 2024, and cut short-term interest rates by a quarter of a percentage point. Long-term interest rates, such as those on the 10-year Treasury note, actually rose by 10 basis points (10 hundredths of a percent) as the Fed itself forecasts few rate cuts in 2025. The inflation and employment prospects have changed significantly in recent months. Business leaders should now expect interest rates to decline very slowly throughout 2025.

The Fed sees a solid labor market and stubborn inflation

Fed officials went into their meeting having seen a solid labor market. The number of jobs increased every month this year. Although the growth rate decreased over the year, it was ultimately in line with population growth. Some other indicators have changed from very positive to moderately positive. The number of voluntary departures has fallen, but is now at the long-term average. The number of job vacancies reported by employers has declined, but is still above pre-2021 levels. And the labor market’s best leading indicator, the number of initial unemployment insurance claims, has increased slightly over the year but is still 40% below its long-term average value. The labor market is therefore experiencing neither a boom nor an upswing, but is rather strong than weak.

The Fed’s dual mandate is to keep employment strong and inflation low. But prices are still rising too quickly compared to the Fed’s target of 2 percent, as measured by the price index of personal consumption expenditures excluding food and energy. Inflation has fallen significantly since its peak in 2022, but remains stubbornly around half a percentage point above target in 2024. Wage rates are also rising and have even accelerated somewhat in recent months, up to four percent. Although wage increases do not cause general inflation, they do indicate inflationary pressures in the economy.

Trump’s economic policies and the Federal Reserve’s response

The Fed is also taking into account the prospect of continued large deficit spending in 2025. In his press conference, Chairman Jerome Powell said that while some members of the policy committee explicitly took likely fiscal policy into account when making forecasts for the coming years, others excluded policy changes from their forecasts , and some did not say whether they included or excluded policy changes. But surely everyone who follows the economy has an opinion about the likely fiscal policies of the second Trump administration. The new President Trump created DOGE to cut federal spending by $2 trillion, but skepticism is high. President Trump significantly increased federal spending in his first term, even before the pandemic. The Fed’s models are sufficiently Keynesian that sustained deficit spending generates economic stimulus. And in the context of a fully operational economy, further stimulus will have an inflationary effect.

Powell also said the Fed would wait until concrete tariff changes were made to analyze how they would affect the economy and inflation. Tariff changes would trigger a one-off price increase rather than sustained inflation.

Immigration policy was not discussed at the press conference, but is likely to be on the minds of political decision-makers. If Trump tightens immigration across the border, as he did in his first term, population growth will fall from over three percent annually to half a percent or less. This will slow the growth of our productive capacity, meaning the economy is likely to receive less stimulus from fiscal and monetary policy. Deportations could not only slow economic growth but actually shrink it, even if they appear unlikely on a large scale.

Why the Fed will slow interest rate changes in 2025

Asked why interest rates were cut given the economic strength and stubborn inflation, Powell said policy was now well positioned to either tighten or ease. He sees a balance between the risk of further inflation and the risk of weaker employment. “We view the risks as two-sided: if we move too slowly and unnecessarily undermine economic activity in the labor market, or if we move too quickly and unnecessarily undermine our progress on inflation. So we’re trying to navigate between those two risks.”

My own guess is that the Fed gave financial markets guidance on what they were going to do and then watched the data move against them. The Fed backed itself into a corner and then decided that doing the wrong thing—cutting interest rates—would be a lesser mistake than disrupting financial markets and losing their credibility.

Looking ahead, the 19 members’ forecasts show that interest rates are expected to fall by just half a percentage point over the course of 2025. These forecasts are not a plan, but rather members’ different expectations of future developments. They contrast with September forecasts, which expected a full percentage point decline in 2025.

Given the current economic and inflation situation, as well as likely policy changes, I agree with the committee’s consensus. But Powell was wise to express his modesty about the Fed’s forecasting ability, a modesty I share. (Humility doesn’t come naturally to me, but years of predictions have helped it grow.)

Business plans and interest rates in 2025

Business leaders assessing their plans for 2025 may need to scale back expectations of falling interest rates. Plans drawn up three months ago probably included more cuts than would actually occur. This change will be particularly important for businesses associated with real estate, capital investments and large consumer purchases.

Contingency planning for a rise in interest rates makes sense despite the Fed’s current expectations. Higher inflation could be triggered by greater spending stimulus due to continued deficit spending combined with slower immigration that limits productive capacity. That would cause the Fed to raise interest rates. This is less likely than the small rate cuts now expected, but certainly a possibility.