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The Fed cut short-term interest rates by a quarter-point on December 18, but it also threw the financial markets into a tizzy by reducing its expected rate cuts in 2025 from four to two. Even making these two reductions will require evidence of further progress in curbing inflation, according to Fed Chair Jerome Powell. The reason the Fed gave for the reduced expectation was that progress on getting the inflation rate back to 2.0% will take a year longer than previously expected, to 2027, according to the Fed’s latest forecast. Possible reasons for that delay include expected higher federal deficits from tax cuts, or higher prices of imported goods because of tariffs the incoming Trump administration is planning. The forecast was significantly less optimistic than the Fed’s previous inflation forecast released at its September meeting.
Yet, Chair Powell himself appears to still be optimistic that inflation will continue to trend down in 2025 and 2026. At his press conference after the rate announcement, Powell repeatedly emphasized that the rate cut made at the December meeting was justified because the labor market is cooling. Lower interest rates should give the economy a bit of a boost and support hiring, the thinking goes. Since the Fed chair usually gets his way in committee votes, Powell’s views matter a great deal. However, it is likely that Powell will wait to ask for further rate cuts until he can point to improvements in inflation reports next year.
Powell is not yet sure what will be the desired “neutral” rate, the hypothetical interest rate at which monetary policy is neither restrictive nor expansive for economic growth. Expect the Fed to continue cutting its benchmark interest rate until the yield on one-month Treasury bills falls to about 3.5%, and the bank prime rate reaches 6.75%, down from its current 7.5%.
The 10-year Treasury yield ticked up to 4.6% after the Fed move, reacting to the higher near-term inflation forecast. And the Fed has not yet included in its forecasts reasons that could boost long-term estimates of inflation, as well: the Congressional Budget Office has estimated federal deficits will average 6% of GDP over the next 10 years under existing tax and spending laws. That doesn’t include an extension of the 2017 Tax Cuts and Jobs Act, which is expected to happen under a Republican Congress and administration. President-elect Donald Trump has also made campaign promises of various other tax cuts that he would enact in a second term. All of these could boost both GDP growth and inflation. The realities of governing after the election could mean that many of these campaign promises will go unfulfilled, but expect long-term interest rates to stay elevated for an extended period of time.
The Fed will continue to reduce its Treasury securities portfolio. Powell has emphasized that it is still the Fed’s goal to lower the overall amount of Treasury debt and mortgage-backed securities it holds, in order to get its portfolio back to an historically more normal level. This gradual reduction in the Fed’s balance sheet could also push yields on longer-term Treasury bonds higher by a small amount since the market will have to soak up more of Washington’s debt, and investors may demand a higher yield to do so.
Recent declines in mortgage rates stopped once long-term Treasury yields started rising again. 30-year mortgage rates will inch closer to 7.0% for now, and 15-year rates will rise above 6.0%. Mortgage rates are still higher than normal relative to Treasuries, but the eventual Fed cuts in short-term rates will boost banks’ lending margins, which should lower mortgage rates a bit, whenever that happens.
Other short-term interest rates will come down at the same pace as the Federal Funds rate. For investors, rates on super-safe money market funds will edge closer to 4%. Rates on consumer loans will improve. Rates on home equity lines of credit are typically connected to the prime rate (now 7.5%), which in turn moves with the Federal Reserve’s benchmark rate. Vehicle financing rates are running about 7.0% for six-year loans to borrowers with good credit. These may not decline much, since they are also affected by what long-term bond yields do.
Top-rated corporate bond yields have edged up in tandem with Treasury yields, but low-rated bond yields have continued on a downward path as recession fears fade almost completely. Before the Fed’s announcement, AAA-rated bonds were yielding 4.8%, BBB-rated bonds 5.4%, and CCC-rated bonds 11.4%.
