By: Mark D. Troutman, PhD, CFP ®
Many people attribute the sage wisdom of “…predictions are hard, especially about the future…” to baseball legend Yogi Berra. In fact, the quote is attributed to physicist Niels Bohr, who advised listeners to be humble in forecasting given uncertainties and unknowns. The past four years have driven that lesson home to me personally.
So, in the spirit of humility, let’s review the year that was and look forward to the year that might be. In summary, 2025 opens with an economy operating at full capacity, yet with distinct risks. For all the reports on improved performance, there was a clear message. Tame inflation, and let Americans get back to business.
The US economy continues to be the envy of the world. The coming year also signals policy change. In short, this economist believes the outlook is bright, with risks to inflation and interest rates. So – remain optimistic and attentive to risk.
Output. 2024 opened with predictions for modest growth and the possibility of recession in the second half of the year. Despite some growth and inflation scares during the year, GDP expanded to a real 2.7% through 3Q24. 2024 finished strong, with modest slowing and promise of continued expansion into 2025.
This expansion, and the broader recovery since 2020 set the US apart from the rest of the world. US consumers proved more resilient than many believed possible as stimulus funds spent out and interest rates continued to rise. The consumer, the final driver of real US GDP growth, remained strong.
Employment (Unemployment). Labor markets remained strong in 2024 with unemployment below historical rates. Employment expanded, though less broadly than many labor market economists would prefer. Unemployment held firm at 4.1% – generally regarded as full employment. Labor markets became less tight but did not fall into recession. Fears that low unemployment would feed inflation did not materialize. Immigration, a contentious issue, stabilized labor markets and allowed employment to expand while containing inflation.
Wage growth – a key driver of inflation in a service based economy – has been moderate at 3.9% This rate is consistent with increases in productivity and inflation. Most important, these levels sustain incomes which in turn support consumption.
Inflation has been the great pain we all have experienced since 2021. Price levels are the highest in history, and we pay more for everything that we use in everyday life. While inflation has slowed in recent years, it has stalled at levels above the desired target of two percent. Supply chains have largely healed, and deficits remain high at over six percent of GDP in a full employment economy.
The latest consumer sentiment report showed a sharp jump – from 2.8% last month to 3.3%. These are the highest expectations of inflation since 2008. Informal comments in the inflation survey indicated a “…buy it before the price goes up” mentality. Consumers represent 70% of US economic activity, so their expectations drive the future. Interest rates, in turn, follow inflation. We remain vigilant for signs of an upturn in inflation.
Interest Rates. The Federal Reserve lowered its policy rate by a full percentage point in 2024. Markets expected four additional cuts in 2025 with short term rates settling in the 3.5% range. The stall in inflation has reduced expectations from four to two cuts. The Chicago Mercantile Exchange (CME) has projected a maximum of two cuts this year. Longer rates have risen on inflation fears and concerns about persistent, large, and potentially growing federal deficits. We expect interest rates to remain elevated and the risks of an upturn are real.
Corporate profits. The ultimate driver of stock prices, have been a bright spot in 2024 rising 6.1% as of 3Q24. Expect profits to hold in 2025 if the conditions of 2024 continue. A JP Morgan survey of its business clients released on 7 January indicated that 75% were confident that revenues would continue to increase in 2025. Stock valuations, while high, have support from profits for now.
Overview for 2025. On January 20th, a new team assumed leadership of the executive branch, tasked by the US Constitution, Article II Section 8 to “…take Care that the Laws be faithfully executed…” The Republican majority in the House and Senate, sworn in on January 3rd will make the laws. An executive branch and congress of the same party (Republican) indicates that policies to extend tax cuts, employ tariffs and reduce regulations will be priorities. The early actions and demonstrable energy of the new administration confirm this view.
While the policy intentions of the new team are evident, the final outcomes will take time to clarify. Slim congressional majorities will slow the legislative process. Bond markets have signaled that high deficits are a concern. This will prompt examination of fiscal policy. We look to the next six months for a clear indication of what is likely in the realm of policy. In increasing likelihood:
- Tariffs. The President has stated a preference to use tariffs and has wide latitude to impose them. We will publish commentary in the coming weeks that months that provides more detail – in plain English. Tariffs are taxes on goods, which raise the risk of inflation. The Executive Order signed on 20 January directed an examination of trade patterns, presumably to refine tariff policy. Early actions indicate a desire to use tariffs to create negotiating leverage in other areas such as immigration policy. Trade is a smaller share of the US economy compared to our many trading partners. So, while inflationary, the actual impact of tariffs will depend on target products and trading partners.
- Immigration. The actual number of undocumented immigrants is unknown, but estimates place the number between ten and twelve million. An immediate removal of the undocumented population would further reduce the 167.5M strong US labor force and tighten labor markets. As with tariffs, the early actions appear forceful but limited to deportations of individuals with existing deportation orders. While a reduction in the labor force risks higher inflation, more targeted actions would reduce inflation risk.
- Tax reform. The conversion of 2017 tax reforms to permanent status will be a high priority for the incoming administration and Congress. As we presented on our October event, these decisions will not become clear until well into 2025, as any adjustments require congressional action. This means that 2025 is a year for tax planning.
- Regulation. The incoming administration is committed to reducing regulations. Brookings Institution published a study in 2022 of the deregulatory impacts of the first Trump administration. The results confirmed a net reduction in regulations but were unable to clearly determine impact. The results favor pro-growth conditions. The overall impact on the economy is less clear, but positive.
- Inflation. Two major initiatives – tariffs and immigration restrictions – have inflationary effects. Tax reform that results in higher deficits also risks inflation. An outright win would be deficit reduction – but narrow congressional majorities and large deficits make this outcome unlikely in the near term. The Federal Reserve has signaled a commitment to return inflation to a two percent benchmark. Do not expect this to happen until 2026, unless there is a recession in 2025 – and none of us is wishing for that.
- Interest Rates. The price of falling inflation has been higher interest rates. We advised our clients to expect “higher for longer” in 2021 and 2022, and our predictions have proved true. Higher inflation implies that rates will remain higher for longer. Higher productivity and falling deficits could result in more favorable conditions. The outcome of policy changes outlined above will make the path of interest rates clearer over the next year. Over the next few months, expect higher rates overall.
Final thoughts. Productivity has improved in the last few years, and the rapid developments in artificial intelligence and other technologies promise higher productivity still. As the introduction information technology revolution showed in the 1990s, productivity improvements can be hard to spot and take a long time to materialize. Free markets and efficient government are powerful combinations that delivered results in the past. We expect this to hold in the future.
Geopolitical tensions and threats of trade wars carry the risk of supply chain disruptions and reignited inflation. Pragmatism and wisdom have guided us through past tensions. Pray that “…the better angels of our nature…” will prevail in times of tension that seem to be growing.
Kirk and I remain optimistic and vigilant. The US economy remains vibrant and a driver of the world economy. We expect the next year to be turbulent and full of change. Output will expand with short term risks of disruption. Inflation will fall in the absence of any policy errors outlined earlier. The fall will be stubborn, slow and will last into 2026. Interest rates will remain higher for longer and will not fall further before the second half of 2025. US industry will remain inventive and innovative. The incoming administration has promised a new age of prosperity. We will see if they deliver for the American people.