December, 2025
In the final months of last year, the Federal Reserve reduced interest rates three times. The federal funds rate declined from a range of 5.25%-5.50% to 4.25%-4.50% during a three-month period as inflation appeared to be declining. Emerging concerns about the impact of impending tariffs and the lack of continued progress in reducing inflation kept the Fed from making additional rate cuts thereafter. Despite inflation plateauing above the Fed’s target level this year, the central bank’s focus recently shifted to a softening labor market, prompting quarter-point rate reductions in both September and October. Now that the Fed has begun cutting rates again for the first time since last December, the typical pattern would be for a series of additional reductions to quickly follow, but that is not certain.
The economy appears to remain very strong. The Fed’s GDPNow model predicts that the economy expanded at a 3.9% annual rate in the third quarter (for comparison, GDP growth for all of last year was 2.8%). Yet employment and hours worked showed very little growth in the three months through September (more current data has been delayed due to the government shutdown). Additionally, alternative data sources suggest that employer payrolls shrank recently and layoffs have increased. These growing signs about the declining health of the labor market warranted greater attention from the Fed. Despite inflation remaining elevated above their 2% target, they began to cut rates again.
The overall unemployment rate rose slightly in September to 4.4%, a continued low level. However, recent college graduates, for example, are finding it more difficult to get a job. Their unemployment rate is 6.5%, about the highest level in a decade, excluding the pandemic unemployment spike. Economists speculate that artificial intelligence may be partly to blame, as those tools can automate work done by low-level workers. Immigration policy and economic uncertainty may also be having an impact on the broader supply and demand for labor. Fed Chair Jerome Powell described it as a “low-firing, low-hiring environment” where layoffs “could very quickly flow into higher unemployment.” He characterized the most recent interest rate reduction as a “risk management cut” in response to the recent batch of weak payroll numbers.
Fed officials are divided over whether additional interest rate cuts are needed, with a growing split between those fearful of further weakness in employment and those concerned about rising prices. On average, however, the committee expects the federal funds rate to continue to be lowered to 3.6% by year end. Longer-term projections are for rates of 3.4% in 2026, 3.1% in 2027 and 3.0% in 2028. This is largely predicated on their forecast for inflation dropping from 3.1% at the end of this year to 2.6%, 2.1% and 2.0% over the next three years. (Note that the Fed doesn’t expect to hit their target for inflation until 2028!)
Investors are now optimistically pricing in additional rate cuts this year and next. Fed policymakers, however, aren’t quite as confident as investors in that outcome. Jerome Powell commented after the most recent rate reduction that additional cuts are “not a foregone conclusion—far from it.”
In the near term, the lack of government data resulting from the shutdown doesn’t make the Fed’s job any easier. How this will impact decisionmakers is unknown. Some economists have argued that the Fed will likely continue along the same path with additional rate cuts until fresh data emerges showing the labor market is on solid ground. The recent reports from multiple private sources indicating continued deterioration in job creation and layoffs also increase support for additional cuts.
Interestingly, if the economy remains strong and the labor market continues with these structural issues, that translates to increasing productivity. Higher productivity means better profit margins. Combined with the possibility of even lower interest rates, those would be powerful tailwinds for the stock market despite currently elevated valuations.
