Federal Reserve Maintains Current Rates

The Federal Reserve, as widely anticipated, decided to maintain the federal-funds rate at its current range of 4.25%-4.50% during its January 2025 meeting. This marks the first instance of the Fed holding rates steady since it began rate cuts in September 2024. Over the last few months, the central bank has reduced rates by a total of 1 percentage point.

Before the September 2024 cuts, rates had been at a plateau of 5.25%-5.50% since July 2023. The Fed’s next steps will depend on incoming data and the potential impact of large tariff hikes, which could disrupt inflation trends.

Inflation Trends and Projections

Federal Reserve Chair Jerome Powell expressed optimism about the trajectory of inflation, stating that the U.S. economy is well-positioned for “further progress on inflation.” The Fed closely monitors the year-over-year growth rate in core Personal Consumption Expenditures (PCE) prices, which stood at 2.8% in November 2024. If the first quarter of 2025 avoids the significant price increases observed in early 2024, core PCE inflation could drop to 2.4% or lower by March 2025.

The Neutral Interest Rate Debate

A central question for the Fed is determining the neutral interest rate—the rate that facilitates balanced economic growth over the long term. While Powell acknowledged that the current rate is above the neutral rate, he also emphasized the uncertainty surrounding its precise value. This uncertainty underscores the Fed’s reliance on incoming data to guide its future policy decisions.

Labor Market Remains Resilient

The labor market has shown signs of stability, with the unemployment rate (three-month average) holding steady at approximately 4.15% in recent months. This marks an improvement from earlier fears of labor market deterioration, as the unemployment rate had previously risen from 3.6% in August 2023 to 4.2% in August 2024, triggering the “Sahm rule” recession indicator.

In light of these developments, the Fed’s official statement removed prior references to “eased” labor market conditions, instead noting that “labor market conditions remain solid.”

Outlook for Future Rate Cuts

The Fed’s cautious stance on future rate cuts is influenced by significant policy uncertainties, including the potential for tariff hikes. Powell highlighted the wide range of possibilities for the economy, emphasizing the unpredictability of future developments.

The market’s reaction to the Fed’s January meeting was muted, with the 2-year U.S. Treasury yield increasing by just 2 basis points. Futures markets adjusted the implied probability of a rate cut for March 2025 slightly downward, from 30% to 20%. Expectations for the year-end 2025 federal-funds rate remain at 3.75%-4.00%.

Morningstar’s Rate Expectations

Morningstar Research holds a more dovish outlook on rate cuts than the market consensus. The firm expects the federal-funds rate to end 2025 in the range of 3.25%-3.50%, implying four rate cuts compared to the market’s expectation of two. Furthermore, Morningstar projects the rate to drop further to 2.25%-2.50% by early 2027, whereas the market anticipates rates to hold steady at 3.75%-4.00% indefinitely.

This outlook is premised on the belief that current rates remain highly restrictive, which is likely to lead to slower GDP growth and a cooling labor market over the next one to two years.