Everyday Economics: Without major policy shifts, U.S. economy likely to slow further in 2025

(The Center Square) — The Federal Reserve lowered the target for the federal funds rate by another quarter point last week while signaling fewer rate cuts in 2025 than previously anticipated.

This approach aligns with the Fed's dual mandate to promote price stability and support the labor market. Headline inflation has accelerated in recent months, and a strong economy has left room for further price growth. Reflecting this, the yield on the benchmark 10-year Treasury has risen nearly 100 basis points since the first rate cut in September.

However, with inflation already below the median FOMC member forecast of 2.5%, the Fed is signaling greater tolerance for a slightly higher inflation rate in 2025. At the same time, a modest softening in the labor market could prompt more rate cuts than currently projected in the latest Summary of Economic Projections.

The labor market clearly remains a key concern for the Fed.

Job openings have fallen significantly over the past year, leaving the labor market looser than it was before the pandemic. While nominal wage growth remains elevated at roughly 4%, it is not a source of inflationary pressures. Job-to-job changes — an important source of wage gains — have fallen drastically.

Absent major policy initiatives from Congress, job gains are likely to underwhelm in the coming year. Slower-than-expected employment and wage growth could also push down the benchmark 10-year Treasury yield, which influences consumer borrowing costs for credit cards, auto loans and mortgages.

The housing market provides further evidence of economic cooling. Historically, housing starts have been a reliable leading indicator of changes in real economic growth. Significant shifts in new home construction often signal broader economic trends, and housing starts are currently 14.6% lower than a year ago. Most housing forecasters have also downgraded their outlook for home sales in 2025.

In past downturns, declining residential investment has been a leading contributor to economic weakness before a recession, followed by reductions in business spending on equipment and software during a recession. Consumer spending tends to be the last domino to fall. While my baseline forecast suggests the U.S. economy will avoid a recession in 2025, the Fed may need to ease policy in the second half of next year to prevent stalling growth in 2026.

That said, early-year data volatility could heighten market fluctuations. Still, with the labor market expected to cool further, the Fed's recalibration of monetary policy is far from complete. Economic risks remain tilted toward a slower pace of growth in the year ahead.