The Fed May Deliver More Rate Cuts In 2025 Than Possibly Anticipated

The Federal Reserve may deliver more interest rate cuts in 2025 than investors currently anticipate, according to State Street.

Michael Arone, chief investment strategist at the $4.7 trillion asset manager, believes the central bank will cut rates more than the single 25-basis-point reduction currently priced in by markets.

Interest rate expectations have shifted dramatically in recent months as persistent inflation, strong economic performance, and potential policy shifts under a second Trump administration complicate the Fed’s outlook.

Just months ago, markets expected as many as four rate cuts in 2025. That expectation has since dropped to just one.

Despite the Fed cutting rates by 100 basis points since September, the 10-year U.S. Treasury yield has climbed by a similar amount, pressuring both stock and bond markets, particularly in late 2024 and early 2025.

However, Arone does not expect these trends to persist and outlines three key reasons why interest rates are likely to move lower this year.

Economic Growth Set to Slow

After strong GDP expansion in 2023 and 2024, Arone expects economic growth to moderate in 2025.

Earlier this week, the Atlanta Fed’s GDPNow forecast estimated fourth-quarter 2024 GDP growth at approximately 3%. That figure was later revised down to 2.1% after incorporating new economic data from the U.S. Census Bureau.

If economic momentum continues to fade in 2025, concerns about the economy’s strength will likely increase, pushing Treasury yields lower.

"It's likely that economic growth will slow this year, putting downward pressure on yields," Arone said.

Disinflation Could Resume

After stalling in recent months, disinflation may regain traction, partly due to favorable year-over-year comparisons, Arone explained.

"Hotter-than-expected inflation data from early 2024 will soon roll off the year-over-year comparisons, leading to more favorable inflation readings in early 2025," Arone said.

Furthermore, owners' equivalent rent—a significant component of the Consumer Price Index—has been slow to adjust but is finally showing signs of cooling, he noted.

Lower-than-expected inflation in 2025 could provide the Fed with the flexibility to continue cutting rates.

"With the federal funds target range at 4 ¼—4 ½ percent, the Fed still has ample room to lower rates, given that it's significantly above the central bank’s preferred inflation measure," Arone said. "If the Fed aims to maintain a real policy rate about 100 basis points above inflation, it could easily cut rates three times, totaling 75 basis points in 2025."

Improved Fiscal Outlook

Despite concerns over government debt levels, Arone expects the U.S. fiscal position to improve in 2025, reducing upward pressure on bond yields.

He anticipates that individual and corporate tax revenues will exceed Congressional Budget Office estimates while entitlement spending will slow as inflation eases.

Additionally, last week’s breach of the debt ceiling will require the Treasury to draw down the Treasury General Account, injecting approximately $700 billion in liquidity into the economy and further easing financial conditions.

"All this could improve the deficit by $300-$400 billion this fiscal year while also alleviating some of the pressure from rising rates and a strengthening U.S. dollar," Arone said.

Market Implications

One of the biggest surprises for investors in 2025 could be the extent of the Fed’s rate cuts. While markets currently expect just one reduction, Arone sees the potential for at least two, possibly three or more.

For wealth advisors and RIAs, the prospect of lower interest rates reinforces the need to reassess fixed-income allocations, duration exposure, and equity positioning. A shift toward more accommodative monetary policy could create opportunities in rate-sensitive assets while alleviating some of the pressure on equities caused by higher yields.

Advisors should prepare for increased market volatility as expectations shift and position portfolios accordingly to capture potential upside while managing downside risks.

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