Interest rate cuts in 2025 may be smaller than expected ~ Credit Sesame

Credit Sesame discusses expectations for interest rate cuts in 2025 and the effect on the stock market.

The Federal Reserve delivered one of the most unpopular rate cuts in recent history at the December 18 meeting, the last in 2024. The Federal Open Market Committee (FOMC) announced a 0.25% rate cut. The news was widely expected, yet the stock market’s reaction was strongly negative. The FOMC is the subgroup of the Federal Reserve that makes monetary policy decisions.

The sour mood among investors is less about the rate cut and more because of the Fed’s updated financial projections. Those projections show inflation may slow the pace of rate cuts in 2025. This change in outlook is a reminder of the limits of the Fed’s power to control inflation.

The Fed shares changing expectations

People expected a 0.25% rate cut, and that’s what they got. It’s what they didn’t expect that was the problem.

Once a quarter, the FOMC releases a set of economic projections. These show the Fed’s expectations for the next few years. They include what the Fed expects from economic growth, the job market, inflation, and the interest rates that the Fed sets.

In September 2024, the Fed’s projections indicated that it expected the Fed funds rate to end 2024 at 4.4%. The Fed’s rate cut to 4.25% to 4.50% on December 18 is consistent with that expectation. However, the updated economic projections released on December 18 differed significantly from the previous set. For one thing, FOMC now expects the Fed funds rate to be 3.9% at the end of next year. The September projections expected the rate to fall to 3.4%.

There was also a change in expectation for where rates are projected to be by the end of 2026. Whereas the FOMC had previously projected them to fall to 2.9%, they now expect them to end 2026 at 3.4%.

In short, over the next couple of years, the Fed still expects the rate to fall, but not as far or as fast as previously thought.

Markets were not satisfied with the rate cut

Rate cuts are usually catnip for investors. But not this time.

The S&P 500 fell by 3% following the Fed’s announcement. Bond rates rose on December 18, which means bond prices fell.

As much as investors like rate cuts, the 0.25% cut was fully expected and already reflected in market prices. However, the FOMC’s updated economic projections showed that it expects future rate cuts to be milder than previously planned. That’s what sent investors yelling, “Sell!”

A reminder of the limits to the Fed’s power

This recent chain of events was a reminder that while the Fed sets monetary policy, it does not do so in isolation. It has to make its decisions in the context of economic developments.

In this case, the Fed accounted for recent signs that inflation may be more stubborn than expected. Faced with that and the prospect of inflationary tariffs next year, the new economic projections show less progress expected toward driving inflation down.

That, in turn, explains the Fed’s expectation that it won’t be able to cut rates as aggressively as previously thought.

Smaller interest rate cuts implications for consumers

Where does this outlook for more stubborn inflation and slower rate cuts leave consumers? Here are some things to expect:

• Get used to the current level of mortgage rates. At 6.72%, 30-year mortgage rates are about a full percentage point lower than when they peaked at the end of October 2023. However, all that progress was made in the last two months of 2023. Since then, mortgage rates have fluctuated but are now higher than they were when this year began. While inflation seems a threat, don’t expect mortgage rates to make much sustained downward progress.
• Savings and CD rates may stay higher for longer. Once the Fed started cutting interest rates, savings account and CD rates started coming down. If your bank has been especially quick to cut rates, it may have overshot the mark, given that the Fed now expects fewer cuts in 2025. This might be a good time to shop around and see if you could do better with another bank.
• Credit card rates may depend more on credit conditions than on the Fed. There was some hope that big interest rate cuts could bring some relief to people with credit card debt. Now, it seems those cuts may be milder than previously expected. Improving your credit score might be a surer way of getting a lower credit card rate than counting on Fed rate cuts to make a difference.
• No free ride for investments. Both stocks and bonds get a lift from falling interest rates. With fewer rate cuts on tap for 2025, stock gains may depend more on individual company earnings performance than an across-the-board boost from falling rates.

The Fed’s change in outlook shows how unpredictable the economy can be. The Fed may control specific interest rate decisions, but they cannot predict with certainty where those rates will be in a year.

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