The US economy was remarkably both strong and resilient throughout 2024. The domestic consumer continued to drive growth with unwavering dedication despite concerns throughout the year that a slowdown...
The US economy was remarkably both strong and resilient throughout 2024. The domestic consumer continued to drive growth with unwavering dedication despite concerns throughout the year that a slowdown was imminent. As demonstrated in the below chart, GDP sustained better than 3% quarter-over-quarter growth for both Q2 and Q3 after starting the year with Q1 at a more modest 1.6% pace. Early forecasts for Q4 vary widely, and actual results will not be known for several months. However, the pace is expected to slow somewhat, and consensus opinion has the current estimate in the low to mid 2% range.
The 4th quarter was filled with noteworthy events and market-impacting news. The US Presidential Election clearly dominated headlines, and the results continue to have far-reaching influences on the markets and economy as plans from the Trump Administration continue to unfold. Additionally, FOMC rate decisions over the course of the quarter garnered a lot of focus and attention. The ongoing battle to conquer inflation, which has meaningfully impacted consumer's wallets and pocketbooks, continues to be a concern.
Hindsight is always 20/20, especially when reviewing noteworthy monetary policy decisions. The Fed appears to continue to guide the economy toward the elusive soft landing. Heading into September, CPI, PPI, and the Fed’s preferred measure of inflation PCE suggested that inflation was trending towards the FOMC’s 2% target rate. Notably, however, 4th quarter economic data raised concerns that the initial 50 basis point rate cut in September and the subsequent dual 25 basis point cuts in November and December may have been a bit presumptive. Despite concerns that a slowing economy and a higher interest rate environment could push the economy toward a recession, we continue to expect the economy to remain on solid enough footing to avoid such an event.
Ongoing Inflation Concerns
Inflation continued its decline from the atmospheric heights reached in 2022 following the excessive federal stimulus in response to the COVID-19 pandemic. However, the devil is in the details in recent months as indicated in the chart below. Though the upward movement is relatively small, each of the primary measures of inflation has stopped their decline and either stalled or reversed direction towards the end of 2024. Core Personal Consumption Expenditures (core-PCE) in blue, the Fed’s preferred inflation measure, has moved upwards from its June low at 2.6%, with most recent data as of this writing for November reaching 3.8%. The other key measures, Consumer Price Index Less Food and Energy (core-CPI) in red and Producer Price Index Less Food and Energy (core-PPI) in green, have shown mixed results. Specifically, core CPI has been stable at around 3.2% since the summer. Core-PPI contrarily has moved from 2.6% to 3.5%. These recent moves are notable as they have sustained higher levels for 5-6 months, suggesting the possibility of a more impactful trend. Furthermore, this reversal occurred well prior to the Fed achieving its desired 2% inflation target. Given the economy's sensitivity to inflation, even relatively minor upticks warrant attention as they may be an early indication that the economy is not out of the woods yet.
Analyzing the individual components of CPI offers insight into how the inflation picture continues to develop. As the below chart indicates, the Core Goods in purple and Energy in red have continued their disinflationary tendencies over the past several months. Naturally, this is constructive as Core Goods comprised of consumer products, including vehicles, household furnishings, and recreational products, did not experience price increases for the entirety of 2024. Energy costs, including gasoline along with electricity and natural gas delivery, showed price acceleration early in 2024; however, more recently, they have demonstrated several months of price decreases. Given the nature of US consumers as the backbone of the domestic economy, affordability for such items is helpful towards its growth. Food in blue, however, continued to demonstrate small but stable inflationary tendencies throughout last year. Naturally, for consumers, the effects of elevated food prices certainly influence disposable income and spending patterns on an ongoing basis.
Source: Bloomberg
The much stickier Core Services component in yellow above remains stubbornly resistant to a decline, though minor progress has been made. Shelter makes up a significant proportion of Core Services and accounts for around 36% of the entire CPI Index. Therefore, its impact on the overall inflation picture is very meaningful. As demonstrated in the chart below, Shelter in Yellow has retreated from peak inflationary levels experienced in early 2023 but remains meaningfully higher than usual. The dual-edged nature of continued inflationary pressures on the housing market, along with higher housing prices and their impact on consumer spending and housing affordability, will be touched upon later.
Source: Bloomberg
Interest Rates
Despite action by the Federal Open Market Commission (FOMC), interest rates have steadily increased following the initial, aggressive 50 basis point rate cut by the Fed in September of last year. To begin, the Federal Funds Effective Rate (Fed Funds) is a very short-term interest rate banks charge each other to borrow money on an overnight basis. The rate is expressed as a target range totaling 25 basis points, and the upper bound is typically referenced to provide context for investors. Interest rates include the full spectrum of rates at which capital is borrowed, including maturities from 1-Day to 30 years. When discussing interest rates for most investors and borrowers, the 10-Year UST is typically referenced as it serves as the benchmark security from which most lending and borrowing is measured, including home mortgages. Thus, when concerns are raised regarding the rise in interest rates as the FOMC is lowering its target rate, the context of the tenor of each rate in question must be referenced.
The chart below illustrates how the FOMC maintained an elevated Fed Funds rate in pink to combat rampant inflation following the COVID-19 pandemic until eventually initiating a 50 basis point rate cut in September, followed by two more cuts in November and December. As previously discussed, at that time, expectations that monetary policy was sufficiently restrictive and inflation data had demonstrated a meaningful move towards the Fed’s 2% target served as justification for the change. Interest rates, as measured by the 10-Year US Treasury note in yellow, bottomed out in mid-September but steadily climbed by over 100 basis points for a variety of reasons, including concerns about the resumption of inflationary pressures upon the economy.
Source: Bloomberg
Frustrated investors are asking, why are rates rising if the Fed is cutting? One of the keys lies in recognizing that the FOMC’s monetary policy initiatives in cutting the Fed Funds Target Rate most directly influence shorter-term debt given the fact that it is literally a 1-day rate. The Committee’s efforts focus on relaxing or tightening policy to influence economic growth. Longer-term debt, such as the 10-year Treasury note, is directly influenced by the opinions of market participants and the impact of inflation on fixed-income investments. When inflationary concerns increase, as they have in recent months, securities that are more sensitive to inflation will respond accordingly. In the case of the 10-Year Treasury, as inflationary concerns increase, investors demand more return on their investment; thus, prices decline, and yields rise.
Another key factor influencing interest rates on longer-term debt is the expectation that the US Treasury under the Trump administration will begin to unwind the policy followed during the Biden administration. Notably, Secretary Yellen received much criticism for the heavy issuance of short-term debt instead of locking in low borrowing costs on behalf of the Federal Government on 10- or 30-year debt when interest rates were at historic lows. Incoming Treasury Secretary Bessent is expected to begin increasing the supply of longer-term Treasury securities, which invariably leads to higher rates for such instruments. Think back to Economics 101 from freshman year in college. As the supply of a product increases, absent outside influences, the price will decline. Since price and yield are inversely related for fixed-income securities, interest rates rise.
The Federal Open Market Committee
Throughout the fourth quarter of 2024, the Fed maintained a consistent, easier monetary policy stance. As previously mentioned, the 50-basis point rate cut in September was followed by two more cuts of 25 basis points each. Guidance from Chair Powell suggested that the FOMC was becoming comfortable that the previous tighter policy stance was effective in sufficiently impacting inflation and driving it lower toward its 2% target.
During the December 18th FOMC press conference, Chair Powell acknowledged the strength of the economy and the Committee’s challenge with threading the needle regarding monetary policy in trying to achieve a more neutral stance. Essentially, if policy restraint is relaxed too quickly, efforts toward reducing inflation could be negatively impacted. Contrarily, if policy restraint is reduced too slowly, economic activity and employment could suffer. Powell indicated that the more recent firmer inflation projections provided impetus for the quarterly Summary of Economic Projections (aka the Dot Plot) for 2025 to shift higher by 50 basis points from the previous September release.
As demonstrated below, based upon FOMC members’ assessments in December, the implied Fed Funds Target rate for 2025 moved upwards from 3.375% to 3.875% per the median projections. The reduction in projected cuts by the Fed indicates a consensus within the Committee recognizing that economic data had become a concern and the uncertainty that inflation may not be tamed. Thus, the implied Fed Funds Target Rate was adjusted upwards to reflect the change in tone.
Source: Bloomberg
Incoming Trump Administration
As of this writing, uncertainty regarding the actual policies of the incoming Trump administration remains a question for the markets to decipher. Even prior to the election, the consensus was that the incoming administration’s policies would be stimulative and inflationary.
Initial indications about Trump's tax policies suggest cuts to both corporate and individual tax rates. Furthermore, he is proposing extending the TCJA, which expires in 2025, and reinstating the SALT deductions. Such measures would put more money in consumers’ pockets and be stimulative in nature, increasing prices due to higher demand for goods and services.
President Trump has been quite vocal about his intention to introduce protectionist policies applying tariffs on imports. Such measures would suggest a higher cost for the consumer and could be inflationary. The devil, however, is in the details, as the size, breadth, and extent of any tariffs can vary widely. Therefore, inflation would be dependent upon the application and execution of such measures. As we know, he is a brash and savvy negotiator. Could Trump’s bravado on tariffs be a bargaining tactic simply to propose strict controls only to adjust accordingly later? Furthermore, it is worth noting that if instituted, increased prices could offset some of the benefits to the consumer from lower taxes.
Immigration policies remain a hot-button issue and certainly have far-reaching impacts on the economy. President Trump’s strong stance on the deportation of immigrants who entered the US illegally is worthy of discussion. The open-border policy under the Biden administration likely propped up the US jobs market and economy with many workers. Deportation would decrease the number of available workers and provide remaining job seekers with bargaining power, likely leading to increased wages and, therefore, higher labor costs. Fewer workers, however, could possibly have a negative impact on economic growth if there are fewer consumers. It remains to be seen how changes to immigration policies would specifically impact the economy and inflation, but it is certainly a topic worthy of our attention.
Government debt is expected to rise under the Trump administration, with suggestions that the already high $36 trillion in borrowings could have as much as $7.5 trillion added over the next decade. The value of a robust economy and efforts for the newly formed DOGE (Department of Government Efficiency) under Elon Musk and Vivek Ramaswamy may help, but their impact is impossible to predict. We are once again presented with meaningful thoughts to consider, yet until we know more details, the true impacts remain unknown.
The Labor Market
The employment picture remains a high-level concern, as evidenced by Chair Powell’s repeated statements that focus on the Fed’s dual mandates of stable prices and maximum employment. Furthermore, one can surmise that the slight uptick in unemployment through the latter half of 2024 could have been the catalyst nudging the FOMC towards cutting rates, given prior evidence that inflation was cooling at that time.
Source: US Bureau of Labor Statistics via FRED
As indicated above, unemployment has been at or above the 4% threshold for the past 7 months. Most economists look at full employment as a range between 4-5%. Therefore, the uptick is not incredibly disconcerting but does warrant our attention. It is also worth noting that unemployment has risen from historic lows following the aggressive stimulus efforts in the post-COVID environment, so a rise from previously subdued levels is a reasonable expectation.
Recent solid employment data, as evidenced by the increase in Nonfarm Payroll data by +212k for November and +256k for December, is a positive sign but could be explained as seasonal fluctuations. The Job Openings and Labor Turnover Survey (JOLTS) has maintained elevated levels since prior to the Covid pandemic. As mentioned earlier, the increase in workers due to immigration patterns provided ample workers to fill available jobs. Will those patterns change with the new administration? The continued elevated number of job openings, as shown below, indicates that employers continue to seek workers but at a diminishing pace. Regardless, there remain sufficient reasons for us to keep an eye on changes to employment data despite the jobs market remaining in relatively good shape.
The Yield Curve
The yield curve was in the process of solidifying its disinversion trend throughout the 4th quarter. An inverted yield curve, which has short-term rates lower than long-term rates, is generally a function of policy action by a central bank to fight off inflation. The FOMC aggressively hiked its overnight lending rate beginning in March 2022, following the COVID-19 pandemic, causing the US Treasury yield curve to sustain its longest period of inversion in history. The recent steepening of the curve began to gain traction well before the Fed’s September rate cut, as Chair Powell & Co. had earlier used the power of the pulpit to suggest a more relaxed policy stance was likely in the future.
Source: Bloomberg
As discussed in previous commentaries, the re-steepening of the yield curve following a period of inversion has historically been a notable event for which economists suggest caution. Specifically, an inverted yield curve has preceded every recession since 1955 (the modern era). The lone exception occurred in 1966 when a recession did not follow a re-steepening of an inverted curve. What about this time?
Aside from the above harbinger of doom warning, the steeper yield curve is a healthy and constructive sign for the economy. Usually, a steeper yield curve suggests that the economy is poised to grow. It typically signals that inflation is likely to increase as economic growth leads to higher prices. Therefore, for several reasons, I must utter the often ill-fated phrase, “This time is different.” I expect the economy to maintain a decent pace of growth through 2025 and avoid an outright recession. The strong economy, decent labor conditions and stimulative Trump policies all create conditions that suggest a recession can be averted.
The Housing Picture
The Shelter component of CPI has contributed to higher inflation over the past several years. The chart below demonstrates the rapid and meaningful upward trend in home prices as measured by the S&P CoreLogic Case-Shiller US National Home Price Index. Towards the latter half of 2024, we can observe a flattening of the trend, suggesting the issue of affordability may be starting to influence demand.
Source: Bloomberg
Rising home prices generally indicate strong demand and suggest a healthy market and robust economy. Furthermore, higher home prices contribute to the wealth effect and can lead to increased spending and support for the economy, as has likely occurred in recent years. A strong housing market, however, is good until it isn’t. Exactly when the time for a market correction to occur remains an ongoing question.
We appear to be nearing the point where the housing market creates some challenges for consumers and the economy. The current higher interest rate environment adds an additional burden to homebuyers as elevated mortgage rates increase the net cost of home purchases and squeeze out some potential buyers. This creates the ripple effect of placing an increased rent burden upon low or middle-income households. Fewer potential homebuyers mean more people must continue to be renters, thus driving up rental prices. Broadly speaking, the US housing market should begin to experience some challenges in 2025. We expect the issues to be more regional in nature. Locations that have benefitted from the recent population shift will likely continue to benefit from growth and opportunity. Contrarily, a decline in population, higher absolute home prices, and affordability issues will create challenges for other parts of the country. Generally, the housing market should remain on solid footing. However, affordability issues will likely cause some problems at the regional level.
The Outlook
First, economic growth has been remarkably robust and should continue in 2025. Though inflation has shown signs of reigniting, and Trump's economic policies are generally likely to be stimulative, the Fed has sufficient room to operate to contain upward price pressure. Thus far, the Fed has avoided a recession, and looking ahead, I expect them to continue to be successful in orchestrating a soft landing for the economy.
I expect interest rates to be “higher for longer” for much of the year. To begin with, the Fed recently indicated a slower pace of rate cuts per the Dot Plot. Additionally, inflation is expected to remain higher than the Fed’s target 2% rate. Finally, steady employment data and reasonably favorable economic growth lend fuel to a higher interest rate environment.
The higher interest rate environment will bring with it a continued steepening of the yield curve, a favorable development for financial services companies. Therefore, banks, insurance companies, and asset management firms should perform well throughout the year. Consumer cyclicals should also see solid performance, as the continued growing economy should provide opportunities to grow. Finally, energy companies should benefit from fundamentals but also the required higher energy consumption and innovation for energy storage and delivery requirements for the exploding technology landscape.
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