Don’t expect interest rates to be cut until at least Q3 ’25
The early 2025 inflation data have reinforced the theme that getting back to 2% inflation will take longer than generally anticipated. This, in turn, is contributing to caution at the Federal Reserve in bringing down interest rates.
The Consumer Price Index (CPI) rose 0.5% in January. The CPI’s non-food and energy component rose almost as much, recording its largest increase in almost two years. Along with other recent inflation data, this suggests that progress has stalled in returning inflation to the Federal Reserve’s 2% target. A measure of wage inflation, average hourly earnings for production and nonsupervisory workers also showed its largest monthly increase in almost two years in January.
Not surprisingly, the Federal Open Market Committee (FOMC) opted to leave interest rates unchanged when it met in January. During his post-meeting press conference, Chair Jerome Powell emphasized the need for additional progress against inflation before resuming interest rate cuts.
Given these developments, the FOMC is likely to keep policy unchanged when it holds its next meeting later this month (the third week of March). It will provide some guidance as to its thinking in the form of its quarterly Summary of Economic Projections (SEP). We expect the SEP to continue to incorporate some rate cuts later this year. However, this will be contingent on additional progress in bringing down inflation. The recent data imply that it won’t be until the second half of the year before the FOMC feels confident enough to resume cutting interest rates.
Impact of policy changes on interest rates
Another factor that will work to induce caution at the Fed is uncertainty about policy. Changes in fiscal, regulatory, tariff and immigration policy have the potential to alter the trajectory of the economy, including the course of inflation. It will take several months after such policy changes are implemented to assess their economic impacts.
There are some hints that economic activity decelerated in the first quarter. Real consumer spending dropped 0.5% in January after growing strongly in the second half of 2024. Some surveys of consumer confidence show declines in overall sentiment and an uptick in inflationary expectations. Equity prices declined in February. However, this should be placed in context: Rising asset prices during the past two years (mostly equities but, to a lesser extent, owner-occupied real estate) have generated exceptionally large increases in household wealth. The February decline in stock prices is small in comparison to the gains that preceded it. This makes it unlikely that the economy is entering a period of sustained retrenchment by consumers.
Although some of the tariffs announced earlier this year have since been deferred, preliminary data show that imports shot up in January in anticipation of possible tariffs. Those data show that goods imports totaled $325.4 billion in January, an increase of $34.6 billion from December. This is an unusually large increase. This anticipatory surge in imports could cushion or delay some of the effects of higher tariffs on consumer prices. It could also delay or smooth out disruptions in manufacturing sectors that use imported parts and materials. We will see how it plays out as more reverberation news comes this week from Canada and Mexico.
This illustrates one of the challenges that the Fed faces in assessing the economy this year. Many of the Trump administration’s policies have the potential to be economically disruptive. However, there are significant questions about the scope and timing of the changes. Moreover, the economy, generally, and the individuals and businesses affected have a fair amount of resiliency and adaptability. The January data on imports highlights this resiliency. Many businesses appear to have developed contingency plans for tariffs and other policy changes and have started to implement them.
In some instances, the adaptation comes via financial markets. During most of the second half of last year, the dollar strengthened against most other currencies in anticipation of tariffs and other protectionist measures. Such developments can mitigate the effects of policy changes. By the second half of the year, the Fed will be in a much better position to assess the ultimate impact of these policy changes. For now, it appears to be inclined to keep interest rates higher for longer than seemed likely a few months ago.
