What to Expect in the Economy and with Interest Rates in 2025

Written by: Sophia Kearney-Lederman - Senior Economist, FHN Financial

2024 was a long year – as they all seem to be these days – with a lot of uncertainty and a lot of moving parts.  As we head into 2025, there are still a lot of questions about the path of the economy and interest rates, in part because there are still many unknowns around what fiscal policy will look like under the incoming administration. The Federal Reserve, which began lowering interest rates in September 2024, expects to continue to ease this year but at a much more gradual pace in part because of the uncertainties around the economic outlook.

Growth

By and large, the US economy enters 2025 in a good place. Real GDP growth started off a little slow in 2024 but picked up steam in the middle of the year and enters 2025 with solid momentum. Full year 2024 real GDP growth is tracking 2.5%-2.7% largely on the back of strong consumer and government spending. The Federal Reserve’s December Summary of Economic Projections (SEP) acknowledged the better-than-expected 2024 growth with the median real GDP projection for 2024 rising to 2.5%, up from the 2.0% projected in September. In the post meeting press conference, Fed Chair Jay Powell repeatedly emphasized his good feelings about where the US economy is and his optimism about where it is heading.

The Fed’s median projection for real GDP growth in 2025 is 2.1% as of December, with forecasts ranging from 1.6% - 2.5%, suggesting no one on the Fed sees large risks to growth this year. At FHN Financial, we forecast real GDP growth of 2.3% in 2025 with the biggest slowdown coming from government spending. President-elect Trump’s domestic economic policy is centered on a transfer of economic power from government to the private sectors. The private sector can support growth, but we anticipate it will take longer than a year to do so. Using tax breaks, tariffs, and deregulation to encourage domestic investment while also initiating deep government cuts to limit government’s role will take time.

Labor Market

One of the biggest policy uncertainties heading into 2025 – and the one with the potential to have the biggest near-term economic impact – is around immigration. Since 2022, labor force growth has been driven by foreign-born workers – both documented and undocumented. This is part of the reason why the economy has been able to grow above potential without stoking wage inflation.  Average hourly earnings growth has slowed from nearly 6.0% in 2022 to 4.0% in 2024. Labor force growth is also why the unemployment rate rose from 3.4% in late 2023 to a peak of 4.3% in July 2024 as it has occurred while hiring has simultaneously been slowing. Since July, however, the unemployment rate has stopped rising and even fallen, ending November at 4.2%.

In 2025, we project the unemployment rate will fall to 3.7%. Our forecast assumes President-elect Trump will shut the border relatively quickly after taking office, bringing labor force growth to a standstill. A period of deportations should follow - not millions but hundreds of thousands - culminating with the passage of a guest-worker bill at the end of the summer. These are all assumptions, however, and it is essentially guaranteed things will not play out exactly this way. What we do know is that an economy is only as productive as its pool of available labor; less workers means less work gets done and worker shortages can be inflationary.   

Inflation

Inflation went on a bit of a rollercoaster ride in 2024. A pickup in consumer inflation in Q1 spooked the Fed away from easing early in the year. Five months of slowing inflation from April to August, however, proved to be sufficient evidence inflation was moving sustainability toward 2.0%, initiating the first fed funds target rate cut in September. Since then, inflation has been neither great nor terrible. The Personal Consumption Expenditures (PCE) index, the Fed’s preferred inflation metric, rose just 0.1% in November, but the year-on-year inflation rate ticked up from 2.3% to 2.4%. Core PCE inflation – consumer prices excluding food & energy costs – also rose 0.1% in November, keeping the year-on-year rate at 2.8%.

2025 is likely to be another bumpy year of even slower progress on the inflation front. At the December meeting, the Fed revised its inflation forecasts higher for 2025, 2026 and 2027, reflecting the slightly higher-than-expected inflation data recently. The Fed median projection for PCE inflation in 2025 is 2.5%, a tenth higher than in 2024. The core PCE median projection is 2.5% in 2025, three-tenths lower than in 2024. We expect inflation will flare up a little bit more than the Fed does in 2025, possibly to 3.0% year-on-year, before starting to move back toward 2.0% in 2026.

The Federal Reserve and Interest Rates

The combination of inflation moving in the wrong direction in 2025, the potential for a drop in the unemployment rate due to changes in immigration policies, and an economy continuing to grow with a two-handle is why we anticipate the Fed will only cut twice in 2025, 25 basis points in Q1 and 25 basis points in Q2. This will put the fed funds target rate at 3.75%-4.0%, aligned with the Fed’s December dot plot median where we anticipate they will hold for an extended period.

With the Fed moving more gradually, the big question is where the ever-elusive neutral rate might be this cycle. The neutral rate is the level at which monetary policy is neither stimulating nor restricting the economy; essentially it is where rates will land when the economy achieves both stable prices and full employment, the Fed’s nirvana. In the Fed’s dot plot, the “longer run” projection reflects participants’ projections for the neutral rate. The longer run median has continued to inch higher, with December’s projection up again, from 2.9% to 3.0%. The expectation neutral is higher this cycle suggests the Fed will not ease as much as anticipated, not just in 2025, but overall. This is part of the reason why long-term yields have risen since September, even as the Fed has been cutting rates.  And in 2025, strong growth and inflation upside are a recipe for yields staying higher in the face of a more patient, still data dependent Fed.

Sophia Kearney-Lederman
Senior Economist, FHN Financial

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