How Inflation, Tariffs, and More Could Affect Your Finances in 2025

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

Interest rates will stay right where they are. The Federal Reserve delivered the expected decision following their first meeting of 2025. They say a good labor market, growing economy, and “somewhat elevated” inflation are providing an opportunity to wait and see. But that’s the opposite of what President Trump is calling for when it comes to rates. There are other potential policies like tariffs that could influence the economy. Preston Caldwell is a senior US economist for Morningstar Investment Management. We discussed the Fed’s decision, the new administration’s direction, and his economic outlook.

Thank you for joining me, Preston.

Fed Meeting January 2025: Was Pausing Interest-Rate Cuts a Good Move?

Preston Caldwell: Thanks for having me, Ivanna.

Hampton: The Fed made three-straight rate cuts to close out 2024. It was a unanimous decision at their January meeting to pause. Was it the correct move? Why or why not?

Caldwell: Just to provide the background, it was widely expected that the Fed would keep its federal-funds rate unchanged at a target range of 4.25% to 4.50%. The Fed had cut by a cumulative 1 percentage point over September to December of last year. And prior to that, the fed-funds rate had been at a very high plateau of 5.25% to 5.50% percent since July 2023.

Now rates are still high. Obviously, we were at zero during the pandemic up until the beginning of 2022. But even compared to the prepandemic years over 2017 to 2019, we averaged a federal-funds rate of 1.6%. So, at current levels, we’re up over 270 basis points compared to that prepandemic baseline.

We’re still in a regime of high interest rates, but I do think the Fed is correct for not being in a hurry based on what the data has been showing. Inflation is getting very close to normal, but we’re not quite there yet, not quite at the Fed’s 2% target. And even though I think ultimately rates need to fall to sustain a healthy rate of economic growth, that need doesn’t seem to be urgent because we don’t see imminent signs of deceleration in terms of economic growth or undo softening in terms of the labor market.

Hampton: And President Trump recently said he will, “Demand that interest rates drop immediately.” The Fed is an independent agency that’s accountable to Congress and the American people. What was Fed Chair Jerome Powell’s response to this?

Caldwell: I think it was appropriate that he was pretty reticent on the topic throughout the whole press conference. He got asked a number of questions hitting on this subject, and this is just a debate that he doesn’t want to get embroiled in. But the Fed has maintained a culture and zealously guarded a culture of independence for the last 40 years now, which they won really under the term of Paul Volcker as Fed chair who quelled the great inflation of the 1970s. That’s not something that’s going to erode overnight. The Fed can continue doing what it’s doing without getting mired in political debates, which don’t even really make sense anyway. Obviously, the president came in with a mandate to bring inflation back to normal, and if you reduce rates too much too soon, then that’s not going to be conducive to accomplishing that goal.

Outlook for Inflation in 2025

Hampton: The Fed called inflation somewhat elevated. The rate is hovering above their 2% target. Talk about why this target seems like it’s just out of reach.

Caldwell: We’re almost there. I’ll say we and the Fed tend to pay most attention to that year-over-year or 12-month growth rate. That smooths out the noise. And that stood at 2.8% in terms of core PCE inflation as of November 2024 data. But if the first quarter of this year doesn’t see a repeat of the bump-up in prices that we saw in the first quarter of last year, then that year-over-year core PCE metric should drop substantially, maybe 2.4% year-over-year or lower by March.

So, if the data comes in in a reasonable way, not even super low inflation, but just we average a 2% rate of month-over-month increases, then that year-over-year rate should drop substantially in the coming months. And that should put the Fed nearly in position to declare mission accomplished on bringing inflation back to target. One thing that we’re seeing that’s really encouraging is housing inflation is really starting to come down, and that was the single biggest factor that kept inflation high in 2024.

How a Strong Jobs Market Fits Into the Fed’s Outlook

Hampton: We’ve seen good jobs numbers lately. How is the strength of the labor market fitting into the outlook for the Fed?

Caldwell: I think it’s been a large factor in why the number of rate cuts that economists in the market expect for 2025 has shifted downward. The market’s not expecting as many rate cuts in 2025 now because back in the fall of last year, it looked like at one point that the labor market was deteriorating substantially, so the unemployment rate ticked up by over 50 basis points. Going over the period from August 2023 to August 2024, unemployment had ticked up by 60 basis points in terms of the three-month moving average, so that triggered the so-called Sahm rule, which is a traditional recession indicator.

But since then, unemployment has been in a holding pattern averaging about 4.15% over the last several months. So, most people have interpreted that as the labor market looking pretty stable now, and the Fed agrees with that assessment. That’s definitely removed a lot, or most of the urgency to cut rates very quickly.

Why Mortgage Rates Rose When Interest Rates Fell

Hampton: We briefly touched on housing, I want to get deeper into it. Mortgage rates have gone up while interest rates fell late last year. Can you explain to folks looking to buy a house why that is and what would it take to get some relief?

Caldwell: That is a very good question, and it’s a little complicated, so bear with me. But if we look at mortgage rates, they tend to be most tied to the longer end of the yield curve. We think about the Fed and what they do in their meetings on a regular basis is adjust the federal-funds rate, which is most tied to the shorter end of the yield curve because it’s an overnight rate.

If you look at something like a short-term, like a three-month Treasury bill, that’s going to correlate very highly with the federal-funds rate. It’s going to move in lockstep with it. But if we look at something like the 10-year Treasury yield, it can very often move in the opposite direction as the federal-funds rate. And the 30-year mortgage rate tends to correlate most tightly with the 10-year Treasury yield.

The 10-year Treasury yield increased from a near-term trough of around 3.6% back in September 2024 to, as of today’s standing, at about 4.6%. So, that’s been a 100-basis-point increase over the same period that the Fed has reduced interest rates. Because of the 30-year mortgage rate’s ties to the 10-year Treasury yield, it’s followed it upward, and so that’s why mortgage rates have increased.

Now as far as why the longer end of the yield curve has increased at the same time that the Fed has been cutting, well that’s because the longer end of the curve is more so driven by expectations of where the fed-funds rate is going to go over the next one to two to three years and beyond as opposed to where it is right now or where it’s going in the very near term. So, because the market has trimmed its expectations of future Fed rate cuts, longer-term yields have risen even as the Fed has been engaged in the actual process of cutting.

When Is the Next Fed Meeting in 2025?

Hampton: Well, thank you for the explanation. We stayed with you. Thank you, Preston, for that. Let’s talk about the Federal Reserve. Their next meeting is scheduled for March, however, some economists are predicting the first rate cut of 2025 would be in June at the earliest. What’s your forecast, Preston?

Caldwell: I do think we will get four rate cuts this year, and I do think most likely that they will cut in March. Although I could see an argument for holding off a bit longer to not only see how the data plays out but also see how policy plays out. But, indeed, if you look at markets, they’re narrowly expecting rates to be held unchanged in March and overall expecting two rate cuts to occur this year altogether.

Are Interest Rates Going Down in 2025?

The reason why I think we’ll get four rate cuts instead of the market’s expected two this year is because I do think inflation, barring major policy changes, which is not my expectation, I do think that inflation will continue to normalize and even get below the Fed’s target by the end of this year. And I also think economic growth will start to slow as the toll of high interest rates continues to exert a strain on the economy, and economic growth starts to slow toward the end of this year, and the labor market starts to soften further, and that will push the Fed to cut more than markets are currently expecting.

And I do think even in 2026 we’ll continue with further rate cuts for that reason and ultimately bring the federal-funds rate down to 2.25% to 2.50% by early 2027, which is much closer to that 1.60% that we averaged in the prepandemic years.

How Mass Deportations Could Affect Businesses and Consumers

Hampton: The Trump administration has started rolling out new policies that some say could heat up inflation. Let’s begin with mass deportations. What could this mean for businesses and consumers?

Caldwell: I wouldn’t necessarily agree with the premise there because if you look over the last year of the Biden administration, certainly the first Trump administration, but even the whole of Obama’s presidency, a normal rate of deportations, depending on how you slice and dice the data, is at least 300,000 or 400,000 per year. That’s 1,000 per day. So, I’m not sure if the anecdotal information we’re getting so far is a huge step change from the normal rate of deportations.

Certainly, I don’t think that the federal government has the resources to deport an additional let’s say half a million to a million more people per year than normal without new legislation. And I’m skeptical that that legislation will be forthcoming and there will be the political wherewithal to deport not only a small selection of people but wide swaths of the labor market, which would be the kind of thing that would be macroeconomically significant in terms of causing inflation to crop back up again.

How US Tariffs Could Affect Consumer Goods Prices

Hampton: What about potential tariffs? There are concerns that it could push up prices at the grocery store.

Caldwell: Tariffs are definitely one area where policy could have a large impact. And I do think there’s a lot of uncertainty here, but my baseline assumption is that we don’t see large tariffs implemented and maintained indefinitely. They could be implemented for, thinking about the 25% tariffs on Canada and Mexico or the 10% across-the-board tariff, that could be something that comes and goes in a week, but is it going to be maintained for years on end and sustain a large prolonged increase in inflation? That I’m more skeptical about.

I do think in what we saw recently with Colombia’s support of this notion that these tariffs are mainly being used as a negotiating tool and not as an end in and of themselves. Indeed, if we look at the first Trump administration in the campaign leading up to that in 2016, there were a few tariffs that are being threatened today that weren’t mentioned in that first episode. And yet the range of trade actions ultimately was fairly restrained in that first administration.

We did have the significant tariffs on China with the average tariff rate going up by about 15 percentage points, but there the impact is somewhat mitigated because if you have tariffs on a single country like that, it’s fairly easy to reroute those exports through third-party countries in order to dodge the tariffs, like Vietnam for example, which is what we saw in a big way last time.

That and because of the fact that a lot of consumer goods were exempted from the tariffs, ultimately mitigated a lot of the inflationary impact. And so I think that is the most likely scenario this time around that we do perhaps see additional tariffs on China, but the impact is mitigated for the aforementioned reasons.

And then when it comes to tariffs against a broader set of trading partners, especially NAFTA trading partners, I think those are most likely to be temporary and just used as a negotiating tactic. But who knows exactly what’s going to happen? There’s certainly a wide range of possibilities, which is part of the reason why Powell was so reluctant to prognosticate on what’s going to come forward.

Tracking Inflation, Financial Conditions, and the Housing Market

Hampton: And finally, what economic data or White House decisions are you watching for over the next few months?

Caldwell: We just covered tariffs in terms of policy, so that’s the main thing there. But in terms of data, like I said, if we do continue to get mild inflation data over the next few months, then that year-over-year inflation metric should fall precipitously because if we don’t repeat what happened in the first quarter of last year, that’ll roll off the 12-month growth rate, and that should drop from 2.8% in terms of core PCE year-over-year inflation to 2.4% or lower within the next few months.

Certainly, I’ll be watching that closely, but again, I’m trying to figure out where financial conditions are going to head. We’ve had just a tremendous increase of 20% or more in US equity prices over the past year. Is that going to continue? Could it run in the reverse direction? We’ve seen a lot of market volatility in response to the latest news on AI developments, DeepSeek coming out of China, and that causing a bit of a selloff. Could that turn into a bigger selloff? That’s something that absolutely is macroeconomically relevant because I do think high asset prices are a major factor that is propping up consumer confidence right now and therefore offsetting the effects of high interest rates because consumers feel wealthier when their portfolio goes up, and that causes them to spend more. Any reverse in that could necessitate that the Fed cut much quicker.

And housing is also a factor. You mentioned high mortgage rates, and I do think that so many homeowners right now or homebuyers are continuing to buy being assuaged by the notion that they can refinance at lower rates down the line, but if rates just keep staying higher for longer, then will that hope evaporate and cause housing demand to deteriorate further? The housing market will be another corner of the economy I’ll be closely watching.

Hampton: You have a laundry list of things to keep track of, Preston. I’m going to check in with you from time to time. Thank you for discussing the Fed’s decision and being here. I really appreciate hearing your insights.

Caldwell: Great conversation. Thanks, Ivanna.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.